USD: 3 Debt Deal Scenarios

If the U.S. government manages to raise the debt ceiling and pass a deficit reduction plan by August 2nd, the U.S. dollar should rally. The reason is because at this stage in time, most people do not expect a permanent deal to be reached and even if it is a watered down version that involves less spending cuts and tax reform than the President had initially hoped for, the mere reality of the debt ceiling being raised would be enough to trigger a relief rally in the greenback. It would also help the U.S. avert a downgrade and default, which has been the main fear driving the sell-off in the U.S. dollar.  $4 trillion is the magic number and the closer we get to that, the more positive it will be for the U.S. dollar.  A deal will most likely take the form of the McConnell-Reid backup plan or the proposal created by the Gang of Six.  The chance of a debt deal being passed by August 1 ^st is less than 50 percent.  

 

Scenario 2 – Temporary Increase to Debt Ceiling – Mildly Dollar Bullish

Previously, President Obama had vehemently opposed a short term increase to the debt ceiling but he has softened his stance over the past week which means the chance of a temporary increase has risen significantly. In fact we believe there is a 60 percent chance that this is the way things will play out next week.  By raising the debt ceiling just enough to cover expenses through August, Obama will have effectively bought himself another month to sort things out.   However before getting too excited, the White House has said they would only support a temporary increase if it is tied to a firm committed agreement on a larger deal to reduce the deficit.  Although this option could lift the dollar temporarily by delaying the risk of a downgrade or default, it simply kicks the can down the road and leaves the market with lingering uncertainty.  As a result, we expect a temporary increase in the debt ceiling to be only mildly dollar bullish.

 

Scenario 3 – Throw Up their Hands and Let the U.S. Default – Very Dollar Bearish

 

The last scenario is the one that the market fears the most which is a default. If the debt ceiling is not raised by August 2 ^nd, , the U.S. government would effectively run out of money and rating agencies would be forced to strip the U.S. of its prized AAA rating.  No one wants this to happen – not even the rating agencies and so we believe the chance of a default is slim.  If the U.S. were to default on its loans by missing a payment, the whole credibility of the U.S. government and dollar denominated assets would come into question. The U.S. dollar’s safe haven status stems directly from the U.S. government’s long history of repaying its loans on time and missing one interest payment is all it takes to strip away this label.   President Obama would also guarantee himself a loss in the next elections, which is something he will avoid aggressively.  In lieu of defaulting, it is more likely that the U.S. Treasury will apply money used for nonessential programs to debt service, buying the U.S. government a bit more time to come up with a longer term deficit reduction program. The Treasury should have enough money to make coupon payments, Social Security, Medicare and Medicaid payments, but other obligations would probably be missed. The U.S. government could also go down the route of California by issuing IOUs with attractive yields but as things stand right now, current legislation does not permit the Treasury to offer IOUs and that would most likely lead to a selective default rating by S&P and Moody’s. In the worst case scenario, the government could also liquidate its massive gold reserve and foreign currency holdings to pay the bills but this would send a very bad message to the market. One way or the other, there is a lot that the U.S. government can do to avoid a default but avoiding a downgrade is more challenging.  If the U.S. were to default on its loans, there would be significant carnage in both the currency and equity markets.

EUR: GREEK DEFAULT DOes NOT TRIGGER CDS PAYMENTS

Based on the price action yesterday, investors reacted very well to the European Union’s second bailout plan for Greece.   The EUR/USD rose more than 200 pips, erasing nearly all of its month to date losses.  However weaker economic data, profit taking and a rating agency action prevented the currency pair from extending its gains. Fitch became the first rating agency to assign a restricted default rating to Greece which almost immediately stripped the euro of its earlier gains. Although there was a lot of enthusiasm about yesterday’s bailout plan, the reality of the matter is that a restricted/ selected or temporary default is still a default.  The only good thing is that any default is only expected to last a few days. Fitch added that it could raise the country’s debt rating back up to junk levels if Greece manages to issue new replacement bonds which could take only days.  For the past few weeks, the market has been obsessed about whether or not Greece would be pushed into default and now that it has, the reaction is rather temperate.  The reason is because this default, which involves a voluntary exchange of debt, is not expected to trigger credit default swap payments according to the International Swaps and Derivatives Association, who decides if a credit event has been triggered.  If an official default was declared by ISDA, the impact on the EUR/USD and the financial market would be far more significant.  Nonetheless, Fitch is only the first rating agency to assign Greece a selected default rating.  Moody’s is currently reviewing the Greek deal and they along with Standard & Poor’s are expected to take similar action as Fitch.  Downgrades in general will sour the mood in the euro and the prospect of more rating actions explains why the EUR/USD has weakened today.   Disappointing economic data also did not help. German business confidence fell to its lowest level in 9 months which is in line with the deterioration seen in other economic reports.   The IFO index fell from 114.5 to 112.9, reflecting deterioration in both current conditions and business expectations.   There has been some talk that the central bank’s next action could be a rate cut instead of a rate hike and these economic reports certainly support that possibility.  Aside from German retail sales and employment numbers, the Eurozone economic calendar is light next week which means that the focus will be on the U.S. debt talks and any other developments on the European sovereign debt front.

GBP: Q2 GDP DUE NEXT WEEK

The British pound traded higher versus the euro while holding steady against the US dollar.  Although the country’s currency has strengthened in recent days, its domestic economy has been hitting a soft patch. With Q2 GDP scheduled for release next Tuesday, there have been many discouraging signs for the recovery. While manufacturing PMI remained over 50, the number has been slowly declining for the last few months. In addition, the service sector is also deteriorating with PMI reading at 57.1 in March versus 53.9 in June. With these two major indexes dropping in the second quarter, although the GDP is expected at 0.2 percent, the market might see a surprise to the downside. Furthermore, while the output was hit by the supply disruption in Japan, plants shut down and workers booked vacation for the long Easter holiday and royal wedding in April. Meanwhile, consumer prices remain at 4.2 percent in June, more than twice of the central bank’s target. As the lackluster growth coupled with high inflation hits the economy, the consumer confidence report scheduled for release on July 28 would be important to watch as well. With doves in control of the Monetary Policy Committee, the market suspects that more negative signs may push the Bank of England to introduce another round of quantitative easing. Looking forward, mortgage approvals will be released on Monday. In addition to the GDP and consumer confidence, the house price index on Friday will show the health of housing market.

CAD: CPI DOWN, RETAIL SALES UP

The Canadian dollar weakened against the greenback while the Australian and New Zealand dollars continued to press higher.   This morning’s economic reports from Canada were mixed.  With consumer prices falling 0.7 percent in June, inflation is not a major threat. In fact, CPI declined by the largest amount since December 2008, leaving the annualized pace of CPI growth at 3.1 percent, down from 3.7 percent. Core prices also fell 0.6 percent, pushing the annualized pace of growth down to 1.3 percent. Even though headline inflationary pressures are well above the long term average, with core price growth below average, the Bank of Canada will be in no rush to raise interest rates even with consumer spending rising more than expected. The reason is because at 0.1 percent growth, retail sales are still anemic but the details are a bit more encouraging with spending less autos rising 0.5 percent due to stronger demand for electronics, appliances, building materials, convenience store items and shoes. Last week’s Bank of Canada monetary policy meeting provided little color on how quickly the BoC will raise interest rates. The central bank dropped the word eventually from the from their monetary policy statement. Previously the BoC said stimulus would be withdrawn “eventually” and the deliberate removal of this word suggests that the BoC is getting closer to raising interest rates. However at the same time they downgraded their growth forecast which means they are weary of the outlook for the Canadian economy and this implies that in reality, the latest economic reports do not push the BoC any closer to raising interest rates.  Next week will be a busy one for the comm. dollars.  Australia starts the week off with inflation numbers which will be followed by the New Zealand trade balance and the Canadian GDP report.  The Reserve Bank of New Zealand also has a monetary policy announcement.  Rates are not expected to be changed but recent economic data could encourage the RBNZ to upgrade their assessment of the economy, which would fuel rate hike expectations.

JPY: HEAT STROKE

The Japanese yen strengthened against all the major currencies with the exception of the Australian and New Zealand dollars as the market oscillated between high and low risk appetites.  No economic data was released today causing the markets to take their cue from the Eurozone and U.S. debt news flows.  Japan’s government is considering going forward with rebuilding projects worth 23-25 trillion yen ($292-317 billion) in the northeast region devastated by the March 11 earthquake and tsunami, a government source said.  Tokyo also sees the need for actual spending of 13 trillion yen in addition to a combined 6 trillion yen already allocated in two extra budgets it has complied since the disaster.  To raise the money, the government is considering issuing special bonds, scaling back other spending plans, and selling national assets.  It will also consider seeking tax hikes to pay for redeeming the bonds.  The central government has also asked civil servants to wear T-shirts and Hawaiian shirts instead of suits and ties in lieu of turning on the air conditioning to help save electricity.  It doesn’t help that temperatures in late June were more than 7 Fahrenheit degrees above average, the highest on record since at least 1961, Japan’s weather office reported.  At the government’s urging, Japanese businesses and residents have been working together to reduce energy consumption in the wake of the natural disasters, which crippled the nuclear power plant at Fukushima.  To date, about two-thirds of Japan’s nuclear reactors have been shut down for safety reviews and inspections exacerbating power constraints.   Japanese car dealers are feeling another constraint: low inventory levels.  As carmakers rush to restore production at their crippled factories, car dealers have been unable to keep their lots fully stocked.  Now in peak selling season, inventories at many area Japanese-brand dealerships remain at half or less of normal levels.  Honda and Toyota recently told their dealers that full production at all factories should resume in September, at least two months ahead of original repair schedules.  Key economic reports on the docket next week include retail sales, manufacturing PMI, household spending, CPI, the unemployment rate and housing starts.   All of these releases will be crucial in telling whether or not the post earthquake recovery has gained solid traction.

AUD/USD: Currency in Play for Next 24 Hours

AUD/USD will be our currency pair in play for Sunday/Monday.   Economic data we expect for release from Australia is the producer price index for Q2 on Sunday at 9:30 PM ET / 13:30 GMT.  From the U.S. on Monday, we expect the Chicago Fed national activity index for the month of June and the Dallas Fed manufacturing acticivty for the month of July at 8:30 AM ET / 12:30 GMT and 10:30 AM ET / 14:30 GMT, respectively.

The AUD/USD is currently trading in an up trend, which we determine using Bollinger bands.  First support is at 1.0800, the upper first standard deviation Bollinger band.  Second support is at the 1.0700 level where the 20-day SMA and two Fibonacci retracements lie.  The 50% retracement lies at that price when drawn from May 2 ^nd ’s high to June 27 ^th ’s low and the 23.6% retracement lies there when drawn from March 16 ^th ’s low to May 2 ^nd ’s high.  Looking up, first resistance should be at 1.0887, the upper second standard deviation Bollinger band and May 11 ^th ’s high.   Past that, second resistance is at 1.1000, a 4 year high reached on May 2 ^nd , 2011.

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• Foreign Investors Sell Dollars with Debt Showdown Looming
• Obama Says Consumers will Face a De Facto Tax with a U.S. Default