Taking Stock of the Effects of the latest U.S. Budget Showdown

October 17, 2013

Two questions in the immediate aftermath of the budget crisis are 1) what has changed and 2) whether those changes improve or harm the dollar’s outlook.

  • The government shutdown and game of political chicken over the debt ceiling means weaker U.S. growth in both the third and fourth quarters from reduced government spending, shaken business and consumer confidence, and the indirect consequences of these factors on other components of aggregate demand.
  • More political skirmishes will occur early in 2014.  The last-minute deal only handled procedural matters, not the substantive fiscal vision differences separating Democrats from Republicans.  In an overused market vernacular, Washington politicians kicked the can down the road, and investors generally believe that remedies delayed lead to worsening problems in the future.  Don’t expect confidence to rebound all the way.
  • Data confusion about the recent U.S. economic performance will be addressed only slowly and not disappear in all instances.  The less that is known about where the economy has just just been, the greater the forecasting error associated with prospects immediately ahead.
  • The onset and pace at which the Fed’s quantitative stimulus will be tapered has been pushed further into the future and will likely be flatter.  Markets now know that the looming government fiscal crisis featured prominently in the FOMC’s reluctance to change its stance at September’s meeting.  Mindful that the Fed’s policy is being guided by data, weaker U.S. growth and greater difficulty interpreting economic statistics argue for no changes before at least March 2014.  The choice of Janet Yellen for the next Fed chairmanship argues for continuation of a data-driven monetary policy.
  • America’s crisis deflected attention from policy and economic circumstances in Japan, Euroland, and emerging markets like India, China, and Brazil.
  • Investors would be foolish to price out the likelihood of future U.S. fiscal disputes or to presume that 11th hour deals will always be reached to prevent a U.S. default.  If the First World War was able to happen against all sensibilities, who’s to say that a U.S. default now and in the future is a non-starter. 
  • Confidence in the U.S. political system may have suffered some permanent damage that could reduce the benefits of the current dollar-centric international monetary system.  The dollar’s preeminence in reserve asset portfolios will not be challenged in the near term, however, but that role has never been sufficient to protect the dollar’s external value from depreciating.
  • This wasn’t the Conservative Right’s last hurrah.  Ted Cruz has solidified his leadership in the Tea Party movement.  The two will feed off one another and learn from their tactical mistakes in the recent fiscal battle.  He’s much smarter and healthier than former Senator Joe McCarthy and seems headed for higher prominence in U.S. political life.  People, as much as the times, determine the course of history.  While market players generally favor fiscal propriety, Cruz pursues his mission with the unnerving zeal of an extremist like Boris Pasternak’s Strelnikov character.  Such fanaticism where ends justify all means will trouble investors.
  • Although President Obama won the standoff, it is unclear whether the power of the presidency will emerge permanently strengthened vis-a-vis the Congress.  The effect on the balance of power of the Federal government versus the fifty state governments is similarly unsettled. 
  • A U.S. government default would have created the mother of all risk-off trades.  That didn’t happen this time, but the potential for such catastrophe as soon as next March continues.

Almost all of the above changes generated dollar negativity.  In fact, the dollar is lower than end-August levels by over 7% against the kiwi and Australian dollar, 4.1% against sterling, 3.3% against the euro, 3.0% against the Swiss franc, and 2.4% versus the loonie.  Declines of only 0.3% against the yuan and 0.2% versus the yen were diminished in the first instance because China’s currency doesn’t float freely and in the other case because yen weakness is a primary objective of Abenomics.  U.S. ten-year sovereign debt differentials against Germany, Britain and Japan are significantly less supportive than a month and a half ago, and U.S. share prices did not advance as much as the German Dax. 

Even before the debt crisis, the dollar was performing significantly more weakly against other industrial economy currencies than analyst were expecting at the start of 2013.  Many thought the dollar would appreciate through 1.2000 per euro, and some imagined a move to 1.100.  Yen depreciation wasn’t projected to run out of steam short of the 100 per dollar barrier.  In trade-weighted terms against all currencies, the greenback proved more resilient because of strength vis-a-vis a number of developing economies with current account deficits.  Now that the default scare has been removed for at least a couple of months, a swift return to August levels doesn’t seem very likely.  The dollar hasn’t been an object of policy attention, as attested by the October 11 communique from G20 central bankers and finance ministers that omitted the usual obligatory paragraph endorsing market-determined exchange rates that are consistent with economic fundamentals.  For more than a year, the euro had a severely negative image because of European politicians repeatedly “kicking the can of proposed reforms down the road.”  This epithet is now being applied most commonly to Washington.  It’s hard to square that stigma with the possibility that an impressive rally in the dollar is about to begin.

Copyright 2013, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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