Negotiations over the fiscal cliff are in deadlock, according to representatives from both sides of the US political spectrum during interviews this weekend. However, rather than spark a flight to quality and a bout of dollar buying it has had virtually no effect and risky assets have extended gains during the London morning. The dollar is lower along with commodity currencies, while the euro, pound and yen are stronger. There is no unifying theme in the markets, for example, the dollar is lower while the yen is higher as the two most popular safe havens in FX move in opposite directions.
Is the market oblivious to the fiscal cliff?
There may be a few reasons for the markets' behaviour this morning. Firstly, we are due to get a wave of economic data from the US this week. Kicking things off this afternoon is ISM manufacturing data, while later this week we have the November ISM service sector survey, factory orders and then on Friday we have non-farm payrolls for November and the unemployment rate. NFP's are expected at 90k while the unemployment rate may stay steady at 7.9%. However, we believe there is a risk that the unemployment rate could rise to 8% due to the disruption we have seen in initial jobless claims over the last month as a result of Super Storm Sandy. Any negative data surprises could push the Fed into even more action at its meeting next week. Operation Twist expires at the end of this year, thus with fiscal issues looming combined with a fragile economic recovery the Fed may choose to extend QE3 to make up for the end of Twist.
Since more QE tends to weaken the dollar, we could see the dollar sell off in the next couple of weeks on the back of negative Fiscal Cliff comments from Washington as the markets look towards more accommodative action from the Fed on the back of the political deadlock. Fiscal cliff discussions could weigh on USDJPY and Treasury yields in the coming weeks. It appears that 83.00 could be a near-term top in this cross. Even with Japan's own fiscal and growth problems the market still doesn't want to fight the Fed, thus we could see investors selling USDJPY on strength in the coming days. Although more stimulus is expected from the Bank of Japan, we believe that a good deal of this is priced in already and we may see USDJPY trade in an 81.50- 83.00 range into year-end. If the US fiscal cliff negotiations continue to go pear-shaped then this cross may sell-off sharply. During the stalemate in Washington during the debt ceiling negotiations in summer 2011, USDJPY dropped 7% between August and September, at the same time the SPX 500 plunged from 1,350 to 1,100. SO there may be further downside from here for US-based assets.
A PMI surprise from the currency bloc
EURUSD had a very bullish close last week above 1.30 after breaking through the top of the daily cloud at 1.2990. It has extended gains today after some respectable PMI data and also details about Greece's debt swap. The PMI data for November picked up in Spain and Germany last month, which helped the pan-European index rise to 46.2 from 45.5 in October. Ireland continues to be the stand out performer, its index rose to 52.4, well in expansion territory, above 52.1 in October. Although the overall Eurozone is still mired in contractionary territory it suggests that the worst may be behind us, after this index has picked up since basing around 45.00 earlier this year.
Political shift in Europe could be a watershed moment for the sovereign crisis
The other "good" fundamental news out of Europe was further details on Greece's debt swap. Athens will buy back EU10bn, and pay between 30-40% of the principal value of the bonds depending on their duration. Thus, these purchases could be used to retire EU30bn if debt. Holders of Greek debt have until Friday to show their interest to participate; the buy-back will be settled on 17th December. This combined with comments from German Chancellor Merkel that suggest she may be warming to a debt write-off for Athens. Euro-based assets are reacting well to these two bits of news because they suggest that the Eurozone authorities are changing their view on how to solve this crisis from pure austerity (like we have seen for the first 2.5 years of this crisis) to debt-sustainability. Hence we have seen Spanish bond yields fall further today and dip below 5.2%, their lowest level since mid-March. This is helping to boost the euro. This week's ECB meeting, where we do not expect any new measures to be announced to help growth or credit risk for the region, is the biggest event risk for the single currency this week. We think EURUSD may be a buy on any dips post the ECB meeting, as the shift in the political debate cheers investors that, finally, European politicians may have a handle on this crisis, which is a far shout from the US.
Watch out for US ISM data this afternoon, which is expected to drop back slightly to 51.5 from 51.7 in October. UK PMI data was also better than expected, which helped to boost GBPUSD earlier. It is close to a key resistance level at 1.6070 - the top of the daily cloud, which may attract some selling interest as we lead up to Chancellor Osborne's Autumn statement on Wednesday. Support lies at 1.60 (200-hr sma) and then 1.5960.
One to watch: GBPUSD daily Ichimoku cloud chart
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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