Did We Just See a Major Power Shift in the FX Markets?

Did We Just See a Major Power Shift in the FX Markets?

It's been a pretty quiet year in the major currency markets for professional investors. Euro vs the USD is the most actively traded currency pair in the 5 trillion USD a day market, and this year its range has been pretty muted, with a high on 1st February of 1.3711 and a low of 1.2746 on 4th April. As an aside, this is one of the reasons that the bulge brackets banks' trading profits are looking quite sick this year.

As I write, on 18th October, the current price is 1.3695 so only a hair's breadth away from the year's highs.

The USD was already suffering as a result of the Fed's no-taper shocker in September and we know what China felt about Washington's stand-off and brinkmanship with the debt ceiling. This week has seen China's ex-deputy head of FX regulation opining that China should cut its holdings of US Treasuries in the medium to long term and the ECB's Nowotny chipping in to say the Euro will play an increasing role as a reserve currency.

The dollar's trouble is that it now seems highly unlikely that the Fed will stop printing money in the near future. The messy denouement of the Washington show means that we will now be subject to another four or maybe even six months of rather unsettling uncertainty.

Although Congress has extended the debt limit to 7th Feb, the US Treasury could then start to use 'extraordinary' accounting measures to live from hand-to-mouth for a few more weeks, as it started doing this year in May, finding some USD 300bn tucked away to prolong the real debt limit deadline to 17th October, (ish). The problem is February and March tend to be a time of heavy tax refunds from the government and on recent experience it will only take a couple of months or so to use up USD 300bn this time, so maybe they could get through to April.This is neither 'nowt nor summat', as we say in Yorkshire. It's not a short enough time for consumers, corporations and the Fed to feel this is all going to be behind us soon, but it's not far enough away for everyone to think, 'whatever, I'll forget about Washington for a year'. It's just about the worst timescale one can imagine.

Consumers will put off purchases , employers will hesitate to hire - in both cases probably not catastrophically, but enough to take the edge off growth - 0.5% in Q4 2013 and Q1 2014 would be my guess. More importantly for the dollar's fortunes the Fed now seems highly unlikely to taper before its March meeting, and there must even be some doubt over that now.

From the Fed's point of view, their key data points are also going to be unreliable. We're now going to see September's employment report next Tuesday 22nd, but the market's reaction function will be heavily skewed-if the numbers are weak. Then they'll be taken to presage an economic dip, if they're strong they'll be discounted as dating from before Washington's antics. The October employment report will now come out on Nov 8th and the 'household survey' used to calculate the unemployment rate will have to conducted retrospectively so that will be tainted and subject to the same interpretation bias. Long story, marginally shorter, this all means it'll be January before the Fed might feel it has 'clean' jobs data to analyse.

In an epic reversal of fortunes, the shutdown/debt ceiling debate has given even the Euro some semblance of safe-haven status and thrown the contrast between the philosophies of the Fed and the ECB into stark relief.

With the OMT still doing its job as virtual sticking plaster, and a Grand Coalition in the making in Germany, there seems little reason why Eur/Usd can't climb towards 1.40 or above before Christmas. That in turn will make the ECB very uneasy, especially given continued low inflation readings which are flirting with the 1% level, traditionally seen as a danger sign for the advent of deflation, and makes a rate cut and/or another LTRO very likely-probably at the December meeting.

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