Sense of Relief Ahead of the Weekend

Confidence has been shaken by the US fiscal behavior, but as the week draws to a close, the fears of a default have eased.   This can be seen in various market measures, including the thinly (though less thin than a month ago) US credit default swaps, where the 1-year peaked at 77 bp at midweek, finished yesterday below last week's high and likely poised to slip further today.  

Japan, Hong Kong, Canada and the US are on holiday on Monday.  We expect more progress over the weekend toward a temporary solution that creates window--maybe six weeks or so--in order to negotiate.  Out of the negotiations, we expect the last minute result to include more spending cuts.  

There will be much chinning wagging from the chattering class on how this just kicks the can down the road.  This may be a too cynical read.  The US deficit has fallen considerably faster than anticipated, and faster than many European countries, who are credited with having a rules-based fiscal plan to reduce deficit.  Moreover, since a large part of the budget involves mandatory commitments, the cuts in spending are heavily weighed toward what is often referred to as the discretionary side.  When we can look back at this period with some perspective, the shrinkage of this part of the federal government will stand out. 

At the same time, the more cynical spin does not sufficiently appreciate the abyss that may have opened as fears of a default grew.  Consider the extensive use of US Treasuries as collateral throughout the financial system.  Already Fed's purchases, which account for a growing share of new supply, given the smaller funding needs, are removing collateral from the market at the same time that regulatory changes require greater collateral.  Add on to this the risk of default on bills and we have the makings of a potential crisis.     There are anecdotes of financial institutions replacing the bills used for collateral with cash, for example.  These, like the larger discount assigned to T-bills for collateral (3% up from 1%) at the Hong Kong Exchanges & Clearing is also small taste of what could happen. 

The steps taken away from the abyss are important then.  Moreover, the spending authority and the debt ceiling issues have come together which means that type of kicking the can down the road previously (resolving the spending authority only to run in to the debt ceiling a few weeks later) has simply changed forms.  It would also not be surprising if some agreement emerges from negotiations to keep the debt ceiling (default) off the agenda through next year's congressional elections. 

After generally trending a bit higher this week, the US dollar is trading heavier, losing ground against all the majors, but the Japanese yen.   The news stream has been light.  Japan reported record strong M3 growth of 3.1% in September.  Of course base money is growing faster as it includes the BOJ asset purchases.  The growth of M3 seems to reflect an increase in corporate cash and demand deposit holdings.  Separately the Corporate Goods Price Index rose 0.3% in line with expectations.  We note the dollar may finish above its 20-day moving average against the yen (~JPY98.20) for the first time since Sept 20.  That said, the JPY98.60 area corresponds to a 50% retracement of the dollar's decline since the last time it was above JPY100 on Sept 11.  The next retracement objective is just above JPY99.00.   Initial support is seen near JPY97.80. 

The main news from Europe, but which only had a brief impact on prices, was the disappointing UK construction report.  Output fell 0.1% in August.  The consensus was for a 0.8% increase.  Some of the disappointment may have been mitigated by the upward revision in the July series to 2.8% from 2.2%.  However, it underscores two points.  First, the divergence with the PMI reading, which in August reached a 6-year high.  Second, it is consistent with other data suggesting the economic momentum may be peaking.  

Sterling initially pulled back modestly on the news, but has extended yesterday's recovery off the roughly $1.5915 low.  We identified a potential topping pattern in sterling  at mid-week and noted that often the neckline is retested.  Sterling has moved above the neckline, that we had identified near $1.5950.  However, the pattern is not negated and we expect resistance to be encountered in the $1.6020-45 area. 

For its part, the euro is recovering off test on the $1.3480 area.  We look for the euro to run out of steam around out of steam below $1.36, around a retracement objective of the decline from last week's highs (~$1.3585).  This area should hold if  a top is being carved out.  

EPFR data reportedly shows the fifteenth consecutive week that European funds experienced inflows.  The fact that Italy and Spain's EU harmonized measures of inflation (0.9% year-over-year and 0.5% respectively) are below German inflation (1.4%) speaks to improved competitiveness.  Yet at the same time, with slow money supply growth, the continued and protracted decline in private credit, the disinflationary environment and a stronger euro and more austerity planned for 2014, euro area challenges remain potent.