Dollar takes the brunt of debt fears

The foreign exchange market seems to be losing faith that the US Congress will reach an agreement to raise the debt ceiling and cut public spending by the 2 August deadline. This has caused a sell-off in the dollar across the board and caused Treasury yields to rise.

We would note that the bulk of negative sentiment is being felt in the FX markets. Treasury yields remain subdued and are only back to levels reached at the start of July. However, data released by the US Treasury yesterday showed that the number of foreign purchasers of US debt fell last week. For now, though, the investment fund community is picking up the slack. However, the US has a lot of debt to sell this week and the markets will be watching closely to see if buyers are faltering as we reach closer to the deadline.

There may be further stress in store for the Treasury market after the CME Group, the US’s largest futures exchange, said it raised margin requirements on US debt futures due to the risks that are building in Washington. The higher margin requirements will cover new trades and current positions and were put into effect at the close of yesterday’s trading. The CME's open outcry trading starts at 1220BST, but electronic trading is 23 hours per day. So far there hasn’t been a large move in the market. However, if other exchanges follow suit, or a deal is not agreed in the coming hours, then pressure could mount on Treasuries.

The latest impasse between the US president and Republicans came late last night and the immediate effect was a dollar sell-off. USD/CHF plunged to a fresh record low below 0.8000, USD/JPY dipped below 78.00 for the first time since the Japanese Tsunami in March. The pair then spiked more than 50 pips before continuing its sell-off. This may have been caused by intervention from the Bank of Japan, but there was no official statement. Regardless, the Japanese authorities have been stepping up their rhetoric about the strong yen and we think that intervention risks have increased in the last couple of days.

While the market is focused on the US debt ceiling, there are some worrying movements in the European credit markets. Italy and Spain are key at this stage to see if the EU debt deal has stopped the spread of contagion. However, bond yields for both member states rose yesterday. Italian yields are back at 5.7 per cent, and Spanish yields are hovering close to 6 per cent. European debt is being treated like a risky asset and is now being sold off along with stocks markets.  While there are heightened tensions in the markets we think that the pressure will remain on Europe’s peripheral debt. Although we believe there are some drawbacks to the EU debt deal and it does not go far enough, for example, it should include an extension of the European Financial Stability Facility rescue fund, we believe the chief driver of peripheral debt this week is risk aversion caused by the impasse on Capitol Hill.

The markets are not very adept at pricing in political risk, so if a deal is found in the coming hours then there could be a swift reversal of sentiment: the dollar may rise, safe havens may come off and stocks and European debt may rally. However, at this stage of the drawn-out negotiations the chance of an amicable solution prior to August 2nd is negligible.

Elsewhere, the UK’s second quarter GDP reading was a mixed bag. Growth was confirmed as sluggish for the second quarter. No one was expecting a stellar figure and the data came in-line with expectations at 0.2 per cent. However, the markets hadn’t been expecting some rather upbeat news from the Office for National Statistics that said if it wasn’t for special factors like the Royal Wedding and the exceptionally late Easter holidays then growth may have been 0.7 per cent over the last three months. Its analysis suggests that the 'special factors' could have depressed the services sector by 0.4 per cent and the production sector by 0.1 per cent.

The market was positioned for a weak number, so this flicker of hope that the UK isn’t about to fall back into recession helped boost sentiment to sterling.

However, although the UK may be able to avoid a recession, the details of the report were mixed. Service sector output rose by 0.5 per cent, government spending on services also boosted growth and production was weak. Overall this is a mediocre reading of GDP, but not as weak as some expected. The detail in the report provided the most interesting reading and showed just how much carnage the global recession did to the UK economy. There is no clear sterling trade from this data, and we continue to expect the pound to be impacted more by what the euro and dollar are doing.

Reserve Bank of Australia Governor Glenn Stevens spoke last night. He didn’t specifically mention monetary policy but he did say there were advantages to a strong Aussie. Inflation data released overnight will be key for the future direction of policy in Australia, and will be an important driver of the Aussie going forward.

Kathleen Brooks is research director at Forex.com

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