US Debt Showdown And Impact On Dollar

  The U.S. government must raise the debt ceiling by August 2 ^nd or face dire consequences.

Let me tell you how bad things can get if the debt ceiling is not increased.  The U.S. has never had anything but a AAA rating and this is the single biggest reason why the U.S. dollar is seen as a safe haven currency.  Investors know that no matter how uncertain the global economy may be, U.S. Treasuries are the safest in the world because the U.S. government has never missed a debt payment.  It is this flight to quality that has kept U.S. interest rates low and the economy supported.  If the U.S. were to lose its AAA rating, foreign investors would start to question the security of U.S. Treasuries and some investors such as China will start to reduce their holdings which would in turn drive U.S. yields higher.  With such an anemic recovery, the U.S. government and the American people will not be able to handle higher borrowing costs.  Stocks would also fall significantly as investors shun U.S. assets and worry that higher yields could eat into profitability.  This is a slippery slope scenario that the U.S. government cannot risk falling into and thankfully the one thing Republicans and Democrats agree on is that the consequences would be very severe. In fact, Standard & Poor’s put the chance of a downgrade at 50 percent which means they believe there is a one in two chance that the U.S. debt ceiling will not be increased in time.  Monetary policy alone gives investors very little reason to own dollars and a downgrade would take away the only reason which is safe haven.

The Republicans have until Saturday to tell President Obama whether any of the 3 options he proposed to trim the budget would win GOP support.  Their choices are:

 

a)    $4 Trillion deficit reduction deal that includes raising taxes and cutting entitlement programs

b)    $2 Trillion deficit reduction package

c)    Much smaller package that would raise the debt ceiling but include no tax increases or cuts to entitlement programs

A back up plan proposed by Republican Senator from Kentucky could also be a viable solution – his plan includes raising the debt limit in 3 stages, totaling $2.5 trillion by next summer – this plan is quickly becoming the most likely option even though it doesn’t directly address the issue.   It only buys the U.S. government time until the economy recovers and tax receipts are significant enough to cover part of the deficit. It doesn’t take much to avoid Armageddon – everyone just has to put their political agendas aside and raise the debt ceiling – which we think is likely to happen.  With no major U.S. economic reports on the calendar next week aside from the Treasury International Capital flow report and housing market data, debt ceiling discussions will be the main focus.

EUR: NO FIREWORKS AFTER STRESS TEST

The EU stress test results are out and despite the sell-off in the EUR/USD, the results were not nearly as bad as investors had feared.   In yesterday’s note, we talked about how 15 was the magic number and only 8 banks failed the test.  Five of those were Spanish banks, 2 were Greek banks and 1 was an Austrian bank.  Every single Italian, German and French bank passed the test even though the 16 banks barely passed according to the European Banking authority.  The goal of the stress tests was to restore investor confidence in the European banking sector and based upon the price action of the EUR/USD following the release it is not clear whether that goal has been achieved.  The EUR/USD initially ran up when investors saw that only 8 banks failed the tests but by the end of the North American session, the currency pair was trading back at its pre-release levels.  The stress tests were more stringent than last years, but only 1 more bank failed the test.   The problem may be due to the fact that the haircuts were applied to the fair value of assets on trading books as of 2010.  When the EBA releases the details of the tests over the weekend, analysts will be running their own models with current CDS prices which mean that the results could be drastically different given how much credit default swap spreads have blown out. Earlier this month, Moody’s ran their own tests and according to their results, almost a third of the 91 banks tested were believed to have needed additional capital.  According to S&P’s tests, 25 percent of the banks failed.  As a result, we could hear more complaints about the tests not being completely accurate after the weekend which may explain why the euro failed to hold onto its gains.  The EU will be holding a special meeting of the Euro area Heads of State on Thursday July 21 to discuss the financial stability of the euro area as a whole and the future financing of Greece.  In the meantime, there will be a heavy dose of European economic data next week that could bring the focus back to the health of the Eurozone economy. Some of the reports scheduled for release include the German ZEW survey of business confidence, Eurozone PMI reports and the German IFO report.

GBP: BOE MINUTES AND RETAIL SALES NEXT WEEK

The British pound weakened against the U.S. dollar and euro as the UK economy further deteriorated.  U.K. home sellers lowered asking prices in July for the first time this year as a mortgage squeeze deterred buyers, according to data leaked two days early.   (The actual release on Sunday will have to confirm this number).  Prices dropped 1.6 percent from the prior month, when they had gained 0.6 percent.   Seven out of ten properties listed in 2011 are still on the market, which Rightmove, an online real estate broker, described as a “sobering reflection” of the market.  The U.K. should experience further home price falls over the next couple months as buyer momentum slows due to a combination of seasonal factors and a continuing lack of both mortgage finance and buyer confidence.   U.K. mortgage approvals have stayed below 51,000 every month since the end of 2009, compared with 128,512 at the end of 2006.  Banks approved 45,940 home loans in May.  The Bank of England left its benchmark interest rate at a record low of 0.5 percent this month to support the economic recovery though the tightest financial squeeze since World War II.  Minutes of the monetary policy meeting are scheduled to be released July 20 ^th and the details of the report will tell us just how likely the BoE will change monetary policy.  Economic data has been very weak and if there is an action to take, it would be to increase and not decrease stimulus.  After the departure of uber hawk Sentance, we were left with a ess hawkish central bank.   Sentance’s replacement Broadbent voted with the majority to keep monetary stimulus unchanged and if anything, recent data has only convinced policymakers that they have made the right decision.   Also coming out next week is nationwide consumer confidence, public sector net borrowing and retail sales.  An upside surprise in retail sales and other economic reports are needed to inject new life into the pound.

CAD: BOC TO LEAVE RATES UNCHANGED NEXT WEEK

While the Australian dollar traded lower versus the greenback, the New Zealand and Canadian dollar strengthened. Increasing concerns over slower growth in Australia has been a big worry for policymakers.  With consumer confidence falling this month by the most since 2008, the Reserve Bank of Australia is facing yet another challenge since the flood in Queensland.  Adding to the pressure on the economy, the new tax on carbon drove business confidence to a 6-month low.  This has caused traders to price in a 40 percent chance of a rate cut from the RBA and whether or not this is really a possibility will partially hinge upon the minutes from the most recent RBA meeting, scheduled for release next week.  As mentioned by our colleague, Boris Schlossberg, Westpac Banking Corp became the first among Australia’s four biggest lenders to predict a cut in the cash rate this year. According to Bill Evans, the chief economist of the bank, Governor Stevens will begin a “sequence of rate cuts” and start by lowering the key rate to 4.5 percent in December. Up north, Canadian manufacturing sales came out lower than forecast today at -0.8 percent. Although economists predicted a 0.2 percent drop, the overall decrease surprised the market with non-durable goods declining 2.4 percent. According to Statistics Canada, the food, petroleum, and coal products were the major contributors to the drop. Since the last Bank of Canada meeting on May 31th, Governor Mark Carney expressed concerns over “substantial headwinds” for the country’s economy. Therefore the target rate is likely to be kept at 1.0 percent on July 18 ^th . As the US economy remains in dangerous zone, Governor Carney stressed the importance of keeping rate stimulative in a June 24 interview with the Wall Street Journal. Furthermore, BoC has revised the economic growth close to 1 percent from the 2 percent forecast in April, largely due to the factory disruptions caused by the disasters in Japan. Although inflation jumped to 3.7 percent, an eight-year high, Carney suggested the spike as transitory and pointed out the low core inflation. Next week, there will be the monetary policy report from BoC on Wednesday and consumer price from Statistics Canada on Friday. Although it will be a quiet week from New Zealand, traders will be watching the CPI report on Sunday. Lastly, as leading index, inflation expectation, and quarterly business confidence come out of Australia, the market will get a better read on RBA’s stance.

JPY: BOJ INTERVENTION RISK

It was a mixed day for the Japanese Yen, which strengthened against some currencies and weakened against others. &nbsp USD/JPY remained under pressure due to the uncertainty related to the debt ceiling. The market has been volatile off the news of the potential U.S. debt rating downgrade and release of EU bank stress tests as traders try to determine what risk view they want to adopt.  The Bank of Japan released the minutes of the monetary policy meeting held on June 13 and 14 today.  It reported that the interest rate had remained below 0.1 percent and will continue to do so as the nation recovers from the devastating March earthquake and tsunami.  Policy board members agreed that the economy continued to face downward pressure, mainly on the production side, but was showing signs of picking up.  They said that indicators released since the last meeting had shown the plunge immediately following the quake had been substantial, but production and domestic private demand had recently been showing signs of picking up.  Supply-side constraints have started to ease and household and business sentiment improved slightly.  Most members agreed that the recovery was proceeding at a faster pace than projected.   Japanese corporate pension funds, with about 60 trillion yen ($760 billion) in assets, may triple their allocations to alternative assets as they seek to diversify and boost returns.  The funds face the world’s lowest bond yield and a falling birthrate, which have curbed contributions.  There is a black market developing in Japan for personal radiation detecting devices known as dosimeters or Geiger counters.  They have sold out and prices have quadrupled in Tokyo.   Residents snatched up the devices after radiation readings in the capital soared more than 20-fold and tap water was temporarily deemed unsafe for infants.  Additionally, reports of contaminated beef surfaced as cattle have eaten straw that came into contact with radiation-positive water.  The economic calendar is relatively quiet next week with only the trade balance scheduled for release on Wednesday.  May’s balance was -0.47 trillion yen and June’s is expected to narrow to -0.25 trillion.  Japan has not had a positive balance since March of this year.  So far, there has also been no sign of the Bank of Japan.

USD/JPY: Currency in Play for Next 24 Hours

USD/JPY will be our pair in play for Monday. Even though there is no data on the docket from Japan, BoJ intervention will remain a potential risk. In addition to the net long-term securities purchases at 9:00AM ET/ 13:00 GMT on Monday, the focus will be on the debt talk in Washington.

With Bernanke talking about more QE and the debt discussions in Washington, gaining little traction, USD/JPY remains in the downtrend, which we determined by Bollinger Bands. If the losses continue, the pair should find support at 78.25, the low on March 17 ^th . Once broken through the level, USD/JPY should bounce off the critical level of 76.39, where G-7 intervened on March 15 ^th . On the flip side, should the pair attempt to climb back, yesterday’s high of 79.59 will provide resistance. As USD/JPY overcomes resistance 1, gains in the pair should be contained at the psychologically significant 81.00 level, where the 50 percent Fibonacci and first upper BB converge.

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