Debt ceiling extension shifts focus temporarily back to Fed
Debt ceiling extension reveals popular pressure on republicans
In the end it looks like the republicans blinked well ahead of the October 17 deadline, or at least "half-blinked". Indeed, the fiscal shutdown that initiated on October 1 (which is not exactly the same as the debt ceiling issue), had already considerably damaged the republicans in the opinion polls, without significantly affecting the standing of President Obama and the Democrats. As such, they decided to give in to a short-term extension without conditions. It is still too early to call the shots on the final outcome of this saga, yet the bargaining position of the Republican side seems to have weakened considerably.
Next week's Beige Book might be more important than usual
At least temporarily markets will now shift their concern away from Congress (fiscal policy) to the Federal Reserve (monetary policy). Moreover, since the shutdown has also affected the delivery of reliable and sufficient statistical data, next week's publication of the Fed's Beige Book (which is a collection of anecdotal evidence on the strength of the economy in the United States), might have more impact than it usually has. There is a concrete risk that the indications out of the Beige Book might be a bit disappointing, as initial jobless claims have recently picked up. More in general, the absence of data combined with continuing uncertainty, might well induce the Fed to further postpone the taper. Or, if they would proceed, they would qualify as being a very bland taper and reserve themselves to reverse it at a minimum sign of weakness.
Nothing new under the sun?
On page 5 we discuss the investment implications of these latest political changes. We see temporary dollar weakness. But we do not think that the prospects for commodity currencies and emerging markets have significantly improved.
Overextended GBP/USD exposed to a slowing UK recovery
BoE to remain on the sidelines in the next months
As widely expected, the Bank of England (BoE) kept its interest rates unchanged at 0.5% and the size of its bond buying programme on hold at £375bn on 10 October. Given the Committee's unanimous stance on the monetary policy last month as well as the recent economic data pointing to a recovery, a more accommodative stance from the BoE is unlikely to occur in the next months. Also, the forward guidance set by the BoE does not call for a rate hike until 2015 at the earliest
The British pound has already priced in a lot of good news
With the BoE likely on the sidelines for the next months, the strength of the UK recovery is likely to influence significantly the valuation of the British pound. Despite being oversold, the recent rise in GBP/USD has been impressive, suggesting that most of the prospect of a robust recovery has been priced in. However, recent weaker than expected retail sales, as well as the surprise decline in industrial production, suggest that the recovery might not be as strong as the market expects. Thus we do not see a compelling medium-term upside potential for GBP/USD at the current prices.
Strong resistances around 1.63-1.64 area in GBP/USD
Looking at the chart, the major resistance area between 1.6302 (30/04/2012 high) and 1.6381 (02/01/2013 high) coupled with long-term declining trendlines confirm that a move above these levels will be hard. In the short-term, the medium-term rising trendline could spur a recovery in GBP/USD, but, in the medium-term, we see the region around 1.63 as an attractive medium-term short opportunity
The never-ending US fiscal saga continues
Nothing new under the sun
What are really the implications of the now very likely six week extension of the debt ceiling? First and foremost, the continuation of the uncertainty is going to prevent the Federal Reserve from taking a very aggressive stance. Thus the US dollar is going to remain under pressure, also versus the euro as the ECB is unlikely to adopt a monetary stance which is significantly more expansive than its current one (over a longer period we still see Europe's single currency weakening against the greenback). Likewise, while we caution against massive strengthening of the pound sterling (see page 4), the Fed's cautious stance is certainly giving some short-term upside potential to cable. And whilst we could also envisage some very short-term strength of commodity currencies, here we really think that the provision of continuing central bank liquidity might well continue to go hand in hand with further weakness of the Aussie, and other natural-resource based currencies. Likewise emerging market currencies are not significantly going to rebound as their commercial surpluses continue to shrink and the vulnerabilities of some emerging markets have clearly come to the forefront, independently of the prospect of the taper at some point in time.
Yet something has changed
The fact that emerging markets and commodity prospects have hardly changed in spite of monetary policy plausibly remaining on hold tells us something interesting about the six week debt ceiling extension. Sometime, as these coming six weeks run their course, we could expect renewed tension as towards the middle of November a deal must be made (or another short-term extension is decided). At that time, all risky assets, such as equities and emerging bonds, might again come under pressure. Thus there is a concrete risk that the prospective weakness of the Japanese yen and the Swiss franc might be short lived.
Aussie and Swissie favoured by purchasing power parity
Three currencies seem too far away from their "fair value"
The purchasing power parity is an economic theory that allows to derive the long-term "fair value" of a currency relative to another. Calculation of this fair value usually derives from either the consumer price index (CPI), the producer price index (PPI). A well-known alternative to general price baskets is the Big Mac Index. The OECD has developed a specific basket that is also widely used. At the end of September, three currencies among the major ones have one or more PPP measures that are viewed as overvalued or undervalued compared to the US dollar, calling for long-term move back to their estimated fair value.
The Aussie and the Swissie remain overvalued
The first one, USD/CHF is overvalued by three measures (CPI, Big Mac and OECD). Given also the SNB's threshold at 1.20 in EUR/CHF and the looming US tapering, we see very little limited medium-term downside risk in USD/CHF.
The AUD/USD is in our opinion much more interesting and overvalued by two measures (CPI and OECD). This overvaluation confirms our longer term bearish view on the AUD/USD. Indeed, the growth rebalancing from the slowing mining sectors to the rest of the economy will force the Reserve Bank of Australia to keep an accommodative monetary policy for an extended period of time, supporting a weak AUD/USD.
The third one, USD/JPY is undervalued by one measure (Big Mac). Yet, we continue to favour further longer term rise in USD/JPY towards 105.50-110.00 given a persistently accommodative Bank of Japan. Thus, given the BoJ's very aggressive unconventional policy, the JPY might weaken further, yet the bulk of weakening might already be beyond us an investors should get cautious above the 105 level.