Bracing for the worst

There was little progress over the weekend during discussions between US politicians attempting to agree on a budget deal and thus avoiding a partial government shutdown by the end of today. The US Senate is now set to reject a House of Representatives plan to delay President Obama’s Affordable Health Care Act while renewing funding for the government until December 15, leaving an ongoing stalemate in discussions.

Markets are bracing for the worst, with risk aversion rising, US equities and the USD falling. Meanwhile US Treasury yields remain capped having dropped sharply since early September. Political shenanigans in the US threaten to overshadow the US September jobs report at the end of the week. Nonetheless, the data will provide major clues to the timing of Fed tapering regardless of the budget/debt discussions.

It’s not just in the US where politics is fuelling market tensions. In Italy former Prime Minister Berlusconi withdrew his party’s support from the coalition government, leaving current Prime Minister Letta scrambling to form a new parliamentary majority in order to avoid snap elections. The impact will likely be felt on Italian and peripheral bond yields over coming days.

Meanwhile following elections in Germany last week coalition discussions to form a new government are ongoing although no deal is in sight yet and talks could go on for some time yet. Political uncertainties are unlikely to alter the European Central Bank’s (ECB) course this week, with an unchanged policy decision expected although benign inflation and weak credit growth will reinforce the need for an easing bias and forward guidance. Political issues are set to dominate markets over coming days, leaving risk aversion elevated and risk assets under generalised pressure.

The USD index lurched lower in the wake of the uncertainties in the US, extending its drop from early September. The near term prospects for the currency are bleak, with limited potential for any upside unless a budget deal is reached. Safe haven currencies in particular the JPY will be buoyed in this environment. The EUR will not fully be able to take advantage of USD weakness however, given the political tensions within the Eurozone.

In terms of high beta emerging market currencies including Asian currencies, any positive impact from the fact that US yields are capped, with 10 year treasury yields dropping sharply recently (higher US yields have been negative for EM currencies over past weeks so a drop will be positive for them) will be outweighed by rising risk aversion, leaving most Asian currencies vulnerable.

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