How Much Will the Dollar Fall on US Government is Shutdown

• How Much Will the Dollar Fall on US Government is Shutdown
• JPY: Prepare for a Big Announcement from Prime Minister Abe
• EUR Unfazed by Weaker German Data
• What to Expect from the RBA
• CAD: Shrugs Off Stronger GDP Growth
• NZD: Official Chinese Manufacturing Data Due
• GBP Extends Gains, Hits Fresh Yearly Highs

How Much Will the Dollar Fall on US Government is Shutdown

Unless members of Congress suddenly shift their tone and put their political differences aside, large parts of the U.S. government is poised for a shutdown at midnight.  We are still holding out hope that there could be a last minute compromise but at this stage the chances are extraordinarily slim.  There's been absolutely no progress on the budget negotiations.  The Senate swiftly rejected the spending bill submitted by the House and they returned a version that strips out a 1 year delay to the Affordable Health Care act.  The proposal of a one-week temporary stop gap measure was also quickly rejected by Republicans who say "it doesn't make any progress in the right direction." In other words, we are right back where we started before the weekend.  At this stage, we have to consider how the U.S. dollar will react if the government is shutdown for the first time in 17 years.  While the shutdown weighed on U.S. equities today, there has been only a limited sell-off in the greenback.  The dollar index lost more than 2% of its value since the beginning of September in anticipation of the dysfunction in Washington but with only a few hours to go before the October 1st deadline, the pressure on politicians to compromise will only intensify.  According to Treasury Secretary Jack Lew, the U.S. government will reach its debt limit no later than October 17th and the U.S. will effectively default on its loans for the first time ever if the debt ceiling is not increased by that date.  The U.S. government has been shutdown 17 times before but it has never defaulted on its debt.  The consequence of doing so borders catastrophic and Republicans and Democrats are both keenly aware of the risks.  So even if a shutdown occurs tonight, Congress has another 16 days to compromise and we firmly believe that they will at bare minimum pass a temporary measure to fund the government for a few more months. 

The last time the U.S. government was shutdown was in late 1995 early 1996 during the Clinton Administration.  The government was actually shutdown twice over a one month period from November 14-19, 1995 and then from December 16, 1995 to January 6, 1996.  As shown in the chart of the dollar index below, in both cases, the dollar dropped only 0.5% while the government was shutdown and recovered quickly thereafter.  Similar price action can be seen in USD/JPY and this leads to believe that while the dollar will most likely extend its losses tomorrow if the government is shutdown, the sell-off should be limited.  Of course if a shutdown is avoided completely, the dollar should enjoy a relief rally that will mean weakness for the EUR/USD and a recovery for USD/JPY.

JPY: Prepare for a Big Announcement from Prime Minister Abe

The Japanese Yen ended the day lower against all of the major currencies.  Tonight is a big night for Japan because Prime Minister Abe is expected to officially announce that the consumption tax will be increased to 8% from 5% in April.  In order to cushion the blow, the Japanese media reported that the Abe will also announce a stimulus package worth more than Y5 trillion that could include a corporate tax cut.  Since the consumption tax has been widely discussed, the official announcement is not expected to have a major impact on the markets unless Abe decides not to raises taxes.  The focus will therefore be on their economic package and growth strategy and how much support to the economy will be provided.  USD/JPY has been trading in a narrow range for the past 12 weeks and fiscal surprises from Washington or Japan could trigger a breakout. If Abe announces a reduction in corporate taxes, it should be good for the Nikkei and in turn the Yen crosses.   The quarterly Tankan survey is also scheduled for release along with household spending, the jobless rate and labor cash earnings.  We are still looking for the data to confirm that Japan's economy is improving even though today's industrial production and retail sales report surprised to the downside. 

EUR Unfazed by Weaker German Data

Italian politics are back in the headlines and despite former Prime Minister Berlusconi's attempt to bring down the government, the euro barely budged. The single currency even managed to shrug off weaker German retail sales growth and the only reason why it has been able to ignore clear signs of political and economic troubles is because investors are reluctant to buy dollars with the U.S. government poised for a shutdown.  The vulnerabilities of the Eurozone economy should eventually catch up to the EUR/USD but that may not happen until Congress manages to compromises on the U.S. debt ceiling.  While Berlusconi ordered five ministers from his People of Freedom Party to resign from the coalition government, opposition within his own party has complicated his plans to bring down the coalition government.  Prime Minister Letta is now poised for a confidence vote on Wednesday and the question is whether other members of the PDL party will break with the PDL and side with Letta.  The country's political troubles only had a limited impact on the euro and Italian stocks and bonds but according to Fitch, these problems put the country's credit rating at risk even if Letta survives the confidence vote.  Meanwhile in Germany, retail sales grew only 0.5% in the month of August.  Economists had been looking for spending to rise by 0.8%.  Tomorrow's German unemployment numbers could finally lend fundamental support to the euro - based on the PMI report employment grew at its fastest pace in 1.5 years and as a result, we are looking for unemployment rolls in Germany to decline by a more significant amount in September.  Of course, German data could take a back seat to the U.S.' fiscal troubles if a government shutdown sends the dollar plunging.

What to Expect from the RBA

The Australian and Canadian dollars ended the North American trading session unchanged against the greenback while the New Zealand dollar trickled higher.  Tonight will be a busy one for the AUD with PMI Manufacturing and Retail Sales numbers scheduled for release along with a Reserve Bank of Australia rate decision.  When we last heard from the central bank, they chose to remove the line "scope to ease policy further" from their statement. This led the market to believe that the RBA is comfortable with the current level of monetary policy and are no longer looking to lower interest rates.  However when the minutes from this meeting was released, the RBA said "the Bank should again neither close off the possibility of reducing rates further nor signal an imminent intention to reduce them."  This meant that interest rates could still be lowered this year especially after this morning's weaker Chinese manufacturing PMI report from HSBC.  Australian data has been mixed with more job losses in August.  So while we don't expect the RBA to lower interest rates, their bias will most likely be dovish which could accelerate the losses for AUD/USD. Meanwhile the Canadian dollar shrugged off stronger GDP numbers.  The economy expanded by 0.6% in the month of July, lifting annualized GDP growth to 1.4% from 1.1%.  With the stress of the construction strike in Quebec and floods in Alberta finally easing, Canada is slowly rising out of its slump.  The commodity currencies appear to be unfazed by the lower final reading of manufacturing activity in China by HSBC in the month of September. Initially, the bank had forecasted stronger growth but today we learned that the sector accelerated only slightly last month, which was a disappointment.  China's official manufacturing PMI report is due tonight and both the AUD and NZD could be affected by its outcome.

GBP Extends Gains, Hits Fresh Yearly Highs

The British pound rose to its strongest level this year against the U.S. dollar thanks to the combination of fiscal troubles in the U.S. and persistent improvements in U.K. data.  After rising for 4 weeks straight, the currency pair is now up over 4% since the beginning of September.  The housing market continues to respond well to low interest rates and the Funding for Lending Scheme.  According to Hometrack's housing survey, prices rose at its fastest pace since May 2007 on the back of solid demand.  This strength was confirmed by higher mortgage approvals and increased lending on dwellings. This trend of upside surprises is expected to continue with tomorrow's U.K. manufacturing PMI report.  Last month, the Confederation of British Industry reported a very sharp rise in manufacturing activity and we believe that this strength will be reflected in the more closely followed PMI report from MarkitEconomics.  At a time when some countries are experiencing slower growth and/or political troubles, the stability of the U.K. government and the consistent improvements in the economy has and should continue to make sterling one of the market's favorite currencies.  If manufacturing activity accelerates at a faster pace, GBP/USD could aim for its 2012 high of 1.6382.