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The probability is very high that the US will not have a debt ceiling deal or a budget deal by the deadline next week, and the ratings agencies will pronounce the US in technical default. The politics don’t matter to either the financial markets or to the voters—it will be a failure of government and on Obama’s watch, offsetting entirely capturing Osama bin Laden. This is what the Republicans want—a big failure on Obama’s watch—and as noted above, they think it will cement the next election. Despicable though the strategy may be, they are probably correct. Pres Obama would have to take some bold action to avoid this outcome, like seizing power under the 14 th Amendment, and we have not seen that kind of boldness from him. It was probably easier to order the Seal Team Six assault on the bin Laden compound in Pakistan than to do the equivalent with Congress.
Now is the time to ask “So What?” The logical expectation would be for interest rates to rise all along the yield curve and the yield curve to steepen, maybe dramatically, as the market incorporates the new risk of some coupon payments being deferred. Stock market responses are harder to figure out—normally a rise in rates siphons money away from equities, but so far equities are rising. In Asia today, every stock market shrugged off the looming disaster in the US and rose, except for India, where the central bank raised interest rates by 0.5% (double the forecast) to 8%. The FTSE All-World index is up 0.5%. The debt crisis is one time when rising yields do not help the dollar, just as rising yields would not help if inflation were outpacing it.
The euro has its own problems and in the longer run, the US has a better chance of economic recovery because it has the institutions in place, whereas the eurozone lacks a Treasury, a bond market, a sufficient bailout fund, and even political permission to take a lot of the actions the leaders are taking. The euro “should” be weaker on the outlook for a lasting recession and presumably would be weaker if the US were in line. But the US is not in line and things are going to get worse before they get better. We haven’t seen yet what the market response willbe because everyone is still hoping that a deal gets done. This is the usual triumph of hope over experience. It is different this time, politically.
The usual outcome in a period of high uncertainty is either a giant rise in volatility (sell options!) or a sideways move that whipsaws you to death. We are probably going to get alternating bouts of both. We would be especially wary as the uero nears the last intermediate high from July 3 around 1.4578. What to bet on? Emerging markets, which have their own metrics and logic.
SPOTCURRENT POSITIONSIGNAL STRENGHTOPEN DATEOPEN RATEPOSITION GAIN/LOSS USD/JPY78.12SHORT USDWEAK06/29/1179.041.18% GBP/USD1.6388LONG GBPSTRONG06/17/111.62900.60% EURO/USD1.4470SHORT EUROWEAK06/17/111.4220-1.76% EURO/JPY113.04SHORT EUROWEAK07/05/11111.23-1.63% EUR/GBP0.829SHORT EUROWEAK07/12/110.8800-0.33% GBP/JPY128.02SHORT GBPSTRONG06/13/11130.742.08% USD/CHF0.8021SHORT USDSTRONG05/27/110.85756.491% USD/CAD0.9433SHORT USDWEAK06/29/110.96602.41% AUD/USD1.0930LONG AUDWEAK07/08/111.07881.32% AUD/JPY85.39SHORT AUDSTRONG07/13/1184.65-0.87% USD/MXN11.6131SHORT USDWEAK06/29/1111.74271.12%
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