FYI | Mar 17 2015
By Kathleen Brooks, Research Director UK EMEA, FOREX.com
This is a momentous week for the US; the FOMC meeting on Wednesday is expected to point towards the first change to rates since 2008. However, something more urgent has also taken place, on Sunday the US broke through its $18 trillion debt ceiling. This is US’s legal debt limit, and is more than US GDP.
The debt limit now needs to be raised or the US government needs to cut spending to try and bring debt levels down. The debt limit was last raised in February 2014 after a 16 day government shut-down in October, which saw hundreds of thousands of workers furloughed and China, a big owner of US Treasuries, start to lose patience at the Congressional stand-off.
This time around financial markets have barely blinked at the US reaching its debt limit. This could be due to “debt limit” fatigue – we have been here before, what’s the worst that could happen? It could also be down to the US not actually running out of money until October, which gives Congress time to reach a deal. However, the government is already taking steps to cut spending including: halting new investments in federal employee pension funds and drawing on a $23 billion currency stabilisation fund.
The consequences of the US flirting with default:
We expect the debate on the debt ceiling to heat up in the coming months, thus it may not be an immediate market concern. However, if it looks like both sides are heading to another government shut-down we may see the rally in stocks and the US dollar hit a road block the closer we get to the October deadline.
To get a sense of how markets may react this time around we can look at what happened to the S&P 500 back in October 2013:
- In the 2 weeks before the government shut-down, during a period of intense government bickering, the S&P 500 fell more than 2.5%.
- After initially stalling, the S&P 500 rallied by 7% from the 9th – 29th October, as a deal was getting closer and then finally announced.
- From the start of 2013 until the government shutdown the S&P 500 rose more than 20%.
- In the 3 months after the government re-opened the S&P 500 rose a further 5%.
As you can see, the government shutdown only had a short-term impact on US stock markets, with markets coming under pressure as the government shut-down loomed large. However, by the time Congress had engaged in discussions and agreed to raise the debt ceiling the markets had already started to move higher. This suggests that these shut downs don’t impact the long-term direction of markets.
Could it be different this time round?
Of course, history does not always repeat itself, and this time the market reaction may not be so sanguine because:
- The S&P 500 is at a record high, so the government shut-down could spook investors and trigger a rush to book profits.
- Likewise, the dollar index is close to a 13 year high, which could also trigger some profit taking if things in Washington get nasty.
- The FOMC may hint at a potential summer rate hike at its meeting this week, which, compounded with a potential government shut down, could weigh on risk sentiment.
- The US economic recovery may have stalled. Although the labour market is growing, it is a lagging indicator, and other data has turned lower including retail sales. This has pushed the Citigroup US economic surprise index to its lowest level since mid-2012. A government shut down could further weigh on the US’s economic prospects, further denting risk sentiment.
Conclusions:
- For now, the strong dollar/ US stock market rally is on and is unlikely to be disrupted by the fact that the US government has reached its debt ceiling.
- However, if the Fed points to a rate hike later this week, on top of concerns about a potential government shut-down later this year, then you could see market sentiment start to slip.
- This could weigh on US stocks more than the US dollar, as a government shut-down could attract safe haven flows into the buck. Back in 2013, the dollar index staged a mild rally during the shutdown (up less than 1%) before eradicating that gain when a deal to re-open the government was announced.
- The government shut-down of 2013 didn’t have a long-term impact on the dollar, with DXY continuing to trade in its prior range after the government re-opened.
We believe that the Fed and the overall economic environment will have more of an impact on the direction of the dollar and US stock markets than the debt ceiling debate. However, if the political rhetoric picks up, and it looks like the US is moving towards a government shut-down in October then risk could take a wobble. For now, we don’t think that it is necessary to take proactive steps to prepare for a government shut-down; however, we will be watching events in Washington closely in the coming months.
Now you can follow us on Twitter: http://twitter.com/FOREXcom
Re-published with permission. Views expressed are not by association FNArena's (see our disclaimer).
Disclaimer: The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase or sale of any currency or CFD contract. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. Any references to historical price movements or levels is informational based on our analysis and we do not represent or warrant that any such movements or levels are likely to reoccur in the future. While the information contained herein was obtained from sources believed to be reliable, the author does not guarantee its accuracy or completeness, nor does the author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.
Futures, Options on Futures, Foreign Exchange and other leveraged products involves significant risk of loss and is not suitable for all investors. Increasing leverage increases risk. Spot Gold and Silver contracts are not subject to regulation under the U.S. Commodity Exchange Act. Contracts for Difference (CFDs) are not available for US residents. Before deciding to trade forex and commodity futures, you should carefully consider your financial objectives, level of experience and risk appetite. Any opinions, news, research, analyses, prices or other information contained herein is intended as general information about the subject matter covered and is provided with the understanding that FOREX.com is not rendering investment, legal, or tax advice. You should consult with appropriate counsel or other advisors on all investment, legal, or tax matters. FOREX.com is regulated by the Commodity Futures Trading Commission (CFTC) in the US, by the Financial Conduct Authority (FCA) in the UK, the Australian Securities and Investment Commission (ASIC) in Australia, and the Financial Services Agency (FSA) in Japan. Please read Characteristics and Risks of Standardized Options (http://www.optionsclearing.com/about/publications/character-risks.jsp).
Technical limitations
If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.