Attention Shifts from US Fiscal Policy to Monetary, Pushes Dollar Lower

A last minute deal was struck that re-opens the US federal government and removes the immediate threat of default, but rather than turn the attention from the US, the focus has shifted from fiscal policy to monetary policy. In particular, the Beige Book yesterday underscored the economic uncertainty sparked by the government shutdown. This coupled with the recent string of private sector data, such as the ADP jobs estimate, ISM, auto sales, some regional Fed surveys and consumer confidence point to some loss of economic momentum. In turn, more investors recognize that the Fed is unlikely to begin any tapering this year.

We have been making the case of tapering under the new Federal Reserve chair. We have argued that although the Fed cuts its GDP forecasts in September, it did not do so sufficiently. Recent developments also then point to another cut in forecasts when these are provided in December. With growth disappointing Fed expectations and price pressures (measured inflation) still below the Fed's target, speculation of tapering in December seemed misplaced.

In addition, we suspect that that will be Bernanke's last meeting. It is true that his term continues through the end of Jan FOMC meeting However, we expect Yellen's appointment to be confirmed in December and recognize the impracticality of having two Federal Reserve chairs. Therefore, shortly after Yellen is confirmed we expect Bernanke to step down.

We have also argued, from a game theory perspective, that it is better for the Federal Reserve as an institution, for the next chair to begin the tapering. The Bernanke Fed has been defined by its response to the financial crisis. Any step in the other direction now, so late in his tenure, will not change this. Instead, the next chair, perceived by many as a dove (and Bernanke's third term), will benefit from managing the shift away from the extraordinary policies (QE3+). In addition, with such little time left in his tenure, Bernanke's forward guidance lacks a certain credibility.

This is one of our key points: It is not just the chairmanship that is about to change at the Fed, but much broader personal changes are likely. There will likely be as many as 3-4 new governors. One regional president who was to rotate on to the FOMC as a voting member next year has already indicated plans to resign. It is better and more credible if post-Bernanke Fed does the tapering and provides the forward guidance.

The dollar's gains seen in the North America yesterday were already being pared in late afternoon dealings.  Asia gently continued this, but the selling pressure turned into a rout in Europe.  We suspect that the US credit downgrade by China's Dagong was merely an excuse.  It cut its assessment of US creditworthiness to A- from A and kept a negative outlook.  Even before today's move, it was well below the triple-A of Moody's and Fitch and even below S&P, which had already taken away the AAA status.  

Dagong's move is not representative of how US Treasuries are perceived.  Yet it plays on fears that the US drama will accelerate the diversification out of dollars and Treasuries.  We do not think those fears are justified.  In fact, last week, while the government was closed, Treasury holdings on the Fed's custody facility for foreign central banks rose by $5 bln.  When the new report is released this afternoon, we expect that custody holdings rose even more, as the purchases conducted at last week's auctions are settled.  

In addition, we note that China's reserves jumped by $164 bln in Q3.  The best way for China to reduce its dependence on the dollar and US Treasuries is to stop accumulating reserves.  As long as it is accumulating reserves, its dilemma remains.  What other market is big enough to absorb those proceeds.  Recall that when the ESM recently issued its first bond it was for about 5 bln euros.  Given the size of China's reserves, or Japan's or the Middle East, and accepting that no investor wants to own the entire issue, the ESM issue hardly moves the proverbial needle.  

The dollar's sharp across the board decline in Europe caught the short-term market wrong-footed.  However, the intra-day momentum indicators are stretched and we suspect the North American session will see the greenback's losses pared.  Just like the euro and sterling frayed support yesterday, they have frayed resistance today.  Similarly, a little more than a week ago, the greenback was flirting with its 200-day moving average against the yen and some saw a breakout.  Playing the break has not worked for short-term traders and we are skeptical that it will begin now.  

That said, we do recognize that of the major currencies, some of sterling's gains can be attributed to a fundamental development.  September retail sales came out on top of expectations and defied softness seen in the BRC report.  Retail sales rose 0.6% compared with the consensus forecast of a 0.4% rise.  And August's 1.0% decline was revised to -0.8%.  The year-over-year pace ticked up to 2.2% from 2.1%.  The gains were broad, with a rebound in food sales (best three month gain in more than a decade) and non-food sales increased at their fastest annual pace since February.  

However, the UK consumer still seems unsure.  In the nine months of data, retail sales have risen 5 times and fallen 4 times.  In addition, with average earnings slowing and now on a 3-month year-over-year view, used to smooth out the noise, up less than 1% and inflation continuing to prove sticky, real purchasing power is being sapped.