Partial Shutdown US Government Weighs on Dollar, but Equities Recover and Bonds Ignore

For the first time in 17 years, parts of the US Federal government have shut down due to a political brinkmanship. Over the past 30 years, it has happened more often than not. It does nothing good for what Ronald Reagan used to call the "shining city on the hill", but the actual material harm appears limited. Estimates of the cost of the shutdown range from 0.007% to 0.01% GDP per day, depending on how many workers are furloughed and for how long.

Yet, investors seem right to look past it. It is unlikely to be very protracted. There seems to be only one solution and the issue is how long will it take to force it. The only solution imaginable is for some part of the Republicans in the House of Representative to stand with the Democrats rather than their own Tea Party faction. This is what happened in August 2011 and again this past New Year's Day.

In the meantime, the US dollar has come under pressure, but the fallout seems limited to the foreign exchange market as global equities are recovering from yesterday's slide, core bond markets are lower, and the periphery, including Italy, Spain, are higher. The MSCI Emerging Stock Index is up about 0.5% and the MSCI Asia Pacific (where China and Hong Kong markets are closed)is up about 0.4%.

Australian shares ended lower, bucking the trend, but this was a function of disappointment with the Reserve Bank. It left rates on hold as expected, but gave those, like ourselves, who are not convinced the easing cycle is complete, little to hang our hats on. The statement said monetary policy was appropriate and appeared to drop the reference to the Australian dollar at a "high level", though noted that depreciation would facilitate the re-balancing of the economy. Separately, there was a string of better economic news. The manufacturing PMI rose to 51.7 from 46.4; August retail sales rose 0.4%, slightly better than the consensus expectations and up from 0.1% in July and house prices accelerated.

The Australian dollar has generally under-performed over the past two weeks, after reaching a high near $0.9530 after the Fed's decision not to taper. Today's advance has brought it with striking distance of last week's high set on Sept 23 near $0.9455 and meeting a retracement objective near $0.9435.

The improved sentiment, especially among large businesses, reflected in Japan's Tankan survey. Sentiment among large manufacturers rose to 12 from 4 and in contrast to the consensus of 7. It is the best reading since before the financial crisis. If there was disappointment, it lies with capital expenditure plans, which slipped to 5.1% from 5.5% in June. The market had looked for an increase to 6%. Also of note Japanese large manufacturers' estimate the dollar to average JPY94.45 during the current fiscal year. This is stronger than the JPY91.20 anticipated in June, but stands well below the JPY97.30, average in the first half of the fiscal year. One way to understand this for equity investors is that as the dollar stays above JPY94.50, large manufacturers may draw extra profits from foreign exchange.

Prime Minister Abe wasted no time to official announce that the retail sales tax increase from 5% to 8% will go ahead starting next April. The supplemental budget will be worked out over the next couple of months, but his initial gambit is for a JPY5 trillion budget. This does not include a corporate tax cut, which the Prime Minister says will be discussed. Talk earlier suggested a JPY6 trillion package with JPY1 trillion in corporate tax cuts. The news therefore was largely in line with expectations.

The dollar initially extended yesterday's recover, moving to almost JPY98.75, but has generally trended lower and return to JPY97.65, which is just above yesterday's low of about JPY97.50.

Contrary to the Australian and Japanese news, the PMI's of China, the euro-area and the UK, and the German and Italian employment reports pointed to economic moderation. China's official manufacturing PMI edged to 51.1 from 51.0. The market had expected a 51.6 reading. While the Chinese economy appears to have stabilized, the lift seems fragile. The euro area manufacturing PMI was unchanged from the flash reading of 51.1, down from 51.4 in August. Germany was revised down from the flash, while France was revised higher. Both Italy and Spain saw some slippage from August, though Ireland improved. It is the third consecutive month the euro area manufacturing PMI is above 50, but the survey data appears to be running ahead of the real sector's performance.

Separately, German unemployment rose 25k after a 9k increase in August (revised from 7k). The market had anticipated a 5k decline. Italy reported its unemployment rose to 12.2%, new record high from 12.1% in July (initially 12.0%). Youth unemployment edged above 40%. We also note that a French computer glitch showed a 50k decline in August unemployment, but the government now says its was more like half as much (22-29k). It has risen nearly 10% against the dollar since mid-July.

The UK's manufacturing PMI came dipped to 56.7 from 57.1 (was 57.2). This is the first decline since February did not derail the sterling express, which pushed through $1.6200, for new highs since early January.

Elsewhere, we note that Norway and Sweden's PMI moved in opposite directions and the price action in the foreign exchange market reflected it. Norway's manufacturing PMI slipped to 52.3 from 53.2 (was 53.0). Sweden's PMI jumped to 56.0 from 52.2. After the Australian dollar, the Swedish krona is the strongest of the major currencies, gaining about 0.75% against the greenback and about 0.65% against the euro. For the better part of the past two months, the euro has been confined to a SEK8.60-SEK8.80 range and over the past week it has been largely limited to the lower half of that range, which remains intact. Meanwhile, the Norwegian krone has extended its loss against the Swedish krone to new lows for the not only this year, but fresh 9-year lows. Technical indicators warn against picking a bottom.

The North American session will be dominated debates over the government shutdown. It means that the economic data, like the manufacturing ISM, construction spending and auto sales are unlikely to be important market movers today. That said, the data is expected to show some moderation from the previous readings.