Dollar Yawns after Elections Awaiting FOMC

Highlights
The dollar was mostly flat in a quiet Asian session with the Tokyo markets closed, even though the dollar experienced sharp losses versus sterling and kiwi. The outcome of the Federal Reserve’s FOMC meeting is also weighing on capital markets (see below). US election results are mostly in and media reports have declared a Republican victory in the House, and a Democratic retention of the Senate. The dollar advance saw EUR/USD dip back below $1.40 but remains a tad above 1.40. At the same time sterling was the G10 strongest performer up 0.5% (1.6147 intraday high) against the dollar following much stronger-than-expected service data. USD/JPY was mired in the narrowest of ranges, JPY80.59-87.  The AUD again touched higher than parity vs the greenback, but after weak building approvals data it slipped back to A$0.9988. EUR/JPY slipped back below JPY113. 

Although Japanese markets were closed for a holiday, most Asian stocks climbed ahead of the FOMC decision.  The MSCI Asia excluding Japan Index was up 1% after strong earnings bank earnings gave the market a boost.  Yet China’s Shanghai was down 0.4% led by a 3.7% loss in materials. European stocks advanced as construction and auto-industry shares climbed.  The Stoxx Europe 600 was up 0.4 led by a 0.5% gain in financials and consumer goods.   At the same time German shares were marginally higher with the Dax up 0.3% led by a 1% gain in consumers.

2-year Treasuries were steady ahead of the FOMC announcement later today, which is expected to result in more quantitative easing, while the 10-year yield was down 2bp. Germany’s 10-year note opened higher, with the yield down 2bp to 2.443%.  Ireland’s 10-year yield continued its ascent up nearly 10 bp followed by a 3bp gain in Greek yields.  Additionally, Portugal plans to sell up to €1 bln of three-and-twelve-month Treasury bills as the nations parliament votes today on next year’s budget draft.   Meanwhile, Iceland’s central bank cut its key lending rate to 5.5%.

Currency Markets

Since it became clear the Fed was going to engage in another round of asset purchases, we expected the dollar to suffer as the market priced it in.  We argued that the uncertainty surrounding next year’s marginal tax rates and the FOMC decision would be lifted here in early November.  After this uncertainty is lifted, we expected the markets to shift the focus toward the certainty in Europe.  That certainty is that the combination of tightening fiscal policies around the corner, coupled with rising short-term interest rates, less liquidity and a stronger euro will act as a significant headwind on business and consumers.  At the same time, we expected the still unresolved debt dynamic issues, under relatively weak political leadership to cause the unresolved debt dynamics to resurface.  The European decision at the end of last week to endorse the German call for a permanent debt crisis mechanism with the emphasis on private sector participation has weighed on the only weak peripheral bond markets in Europe.  Irish bonds, for example, are lower for the 8^thconsecutive session today and the premium against Germany has doubled in the past 3-months.  With today’s decline, the Greek 10-year bond’s losing streak is the longest since April.  ECB President Trichet has expressed concern that the German initiative cut undermine peripheral bond markets as it essentially warns investors that after 2013 that debt restructuring will replace tax payer bailouts.  German Chancellor Merkel acknowledged that she disagrees with Trichet on the level of risk.  This could be an interesting line of questioning at Trichet’s press conference tomorrow. 

The US midterm election results are mostly in with a few races still too close to call but overall it is clear that the Republicans have won a sweeping majority to capture the house.  Though the Senate results are not tallied, it appears that the Democrats will maintain a slim majority, leading to the biggest power shift since 1994.  The results spell out the prospect of political gridlock ahead yet the currency markets appears to be focused on the upcoming FOMC meeting.  The changing political landscape, however, may have implications for the dollar over the medium-term.  One implication seems certain, that is the new shape of government will be less prone to extend fiscal stimulus and more prone to fiscal austerity, placing a lot of weight on the Fed to stoke economic recovery.  If strong growth fails to materialize the Fed may be forced to continue the heavy lifting.

Over the long-term continued reliance on the Fed to drive economic growth could be negative for the dollar, although medium-term budget cuts would be a positive sign for the burgeoning government deficit.  That said, the other implication for the markets has to do with the Bush tax cuts which are largely expected to be fully extended after the GOP’s victory.  The Bush tax cuts, in particular, are current law so further extending them would not be fiscal stimulus but full extension will be negative for the long-term budget outlook.  The Democrats, however, favor a lapse in the tax cuts for the rich, while making them permanent for the middle class.  Meanwhile, the GOP favor full extension, which according to CBO estimates would cost around $3.7 trn over the next 10 years, thereby exasperating deficits down the road.  Overall, reduction deficit is key to dollar stability over the long-term and prudent policy would call for a mix of spending cuts and tax hikes alike.  Yet last night’s election highlight the downside risk of reconciliation that may not impact the dollar now but may stoke trouble down the road if budget issues are not addressed. 

U.K. October services PMI unexpectedly improved to 53.2 from 52.8 in September, against the consensus survey median of 52.6 and hitting the highest level since June. The rise follows an equally unexpected rise to the manufacturing PMI earlier this week and has placed downward pressure on Gilts, as it eases fears over the possibility of a double-dip recession. However, the business expectations sub-index fell on the back of fears over impact from government spending cuts. Indeed, the U.K. recovery outlook remains uncertain but QE expectations continue to diminish.

Upcoming Economic Releases

At 8:15 EST/12:15 GMT the US reports October’s ADP Employment Survey.  The market consensus is for a 20k increase following a -39k drop the previous month. At 10:00 EST/14:00 GMT the US October Non-Manufacturing ISM and factory orders are expected to show small increases. US auto sales will be reported during the day and are expected be the strongest more than a year.  Mexico reports October’s IMEF manufacturing index at 12:00 EST/16:00 GMT, which is expected to increase slightly from the previous month.   At 09:00 EST/13:00 the Treasury announces the size of the quarterly refunding and around2:15 EST / 18:15 GMT the FOMC decision.