In Ugly Contest, US Moves into the Lead

The stalemate in Washington has eclipsed the Greek tragedy to be the main driver of the foreign exchange market.  The US dollar has sold off hard as a credit downgrade and possible default looms closer.  The Aug 2 deadline seems rather soft as indications suggest US government revenues rose recently more than projected and outlays were less than expected.   

The euro rose to its best level since July 5 and key resistance is now seen in the $1.4580-$1.4600 area.  Initial support is seen near $1.4450, but the technical tone is likely to remain positive provided the $1.4360-$1.4400 area remains intact. 

While recognizing that CDS pricing, especially for sovereigns is no Holy Grail, it is noteworthy that despite the fiscal wrangling in the US, the 5-year CDS for the US is priced lower than the German CDS.  The German CDS is trading at a 10% premium to the US.  On balance it would seem to give credence to the view that the US deficit debate is primarily understood as political machinations (with serious consequences for sure), while Europe's challenge still appears more profound.    The US 10-year yield continues to straddle the 3% area, seeming to reflect still relative minor debt market impact from the wrangling.

The fact that Greece will be in selective default and bond holders, who participate in the new schemes, will write down approximately 21% as part of the exchanges, but may not count as a credit event--determined by ISDA--threatens the sanctity of the sovereign CDS market.  They--the credit default swaps--were bought for protection, but will offer no protection, at least in this round. 

Although European officials may be quite pleased with themselves if this is indeed the outcome, it is a problem for European banks and their share prices have fallen.  

The dollar briefly dipped below JPY78 to reach its lowest level since the coordinated intervention in March.  Although there seems to be heightened alert about potential intervention, the risk, I suggest remains minimal.  The key to intervention is volatility not level.  Three month implied volatility has crept up but it remains relatively subdued at about 10.4%.  This is still below the 100 and 200 day average measures, both of which come in near 10.85%.  Recall the coordinated intervention took place when vol was over 17%.   The unilateral intervention took place when when vol was over 13%.   There is not sign that the yen's strength has become destabilizing and the Japanese economy is still recovering from the spring tragedy.  Some large Japanese companies are aiming to be competitive with the dollar near JPY80--so the deviation remains relatively small.  

UK Q2 GDP report was in line with consensus forecast of a 0.2% increase.  The UK economy has for all practical purposes stagnated, but sterling is moving higher.    Its strength appears to be a function of it being a liquid alternative to the euro and dollar.  It is trying to establish a foothold above $1.6375.  If it succeeds, there is potential toward $1.65 and then $1.67.  Key support is seen near $1.6260.