Global currencies and equity markets have been trading in a risk-off environment because of the gridlock in Washington. Ever since the American government shutdown on October 1, there has been a heightened level of uncertainty that has seeped into the financial markets.
The debate between Republicans and Democrats and the lack of consensus thus far have caused the US dollar to strengthen as a result of the risk-off sentiment. This debate is set to culminate when Congress casts its debt-ceiling vote on Thursday.
A risk-off environment exists when market participants avoid high-risk investments such as higher-yielding currencies and equity markets, and instead there is a phenomenon of a flight to safety, an environment in which government treasuries such as the US dollar, the US 10-year bond and the German bund thrive.
On the other hand, a risk-on environment exists when investors are confident enough that the markets pose no such risk, enabling market participants to flee to equity, or take more risks.
In the current market climate, when there is a heightened level of uncertainty, usually associated with breakdowns in the political process or any other such financial calamity which markets perhaps would not usually be positioned, the US dollar and the yen are the biggest beneficiaries along with US and German government bonds.
To return to the unfolding drama in the United States, both parties are using political leverage in the lead-up to Thursday’s vote to get their respective agendas passed. This vote is absolutely critical, as the result will prove a game-changer in determining the pricing in the months ahead.
The best-case scenario would be a compromise and the vote gets passed on Thursday. This will allow confidence and optimism to return to global markets. The scenario, which is likely, will result in the weakening of the US dollar, with the risk-on appetite bouncing back.
On the flip side, if no last-minute deal is brokered, this could lead to a calamity in global financial markets that will make Lehman Brothers look like a children’s picnic.
And since the UAE dirham is pegged to the US dollar, we can expect any weakness in the dollar to pull down other major traded currencies in the region, such as sterling, the euro, the yen and the Indian rupee.
In the case of the British pound, improving domestic economic figures from the United Kingdom and the likelihood of a positive resolution in Washington can allow sterling to gain some ground against the dollar.
Recent UK industrial production and manufacturing figures beat the lower-end expectations. Moreover, the most recent IMF growth forecast for Britain indicates that Britain is set to grow at double the rate as previously expected at the beginning of the summer.
The IMF revised the UK’s growth this week to 1.4 per cent this year and 1.9 per cent in 2014, up from 0.9 per cent and 1.5 per cent, which makes it a very encouraging picture for the British pound, going forward.
With regards to the euro, the positive outcome of the Italian vote of confidence in the government has resulted in the currency making some nice gains.
However, during the most recent meeting of the European Central Bank at the beginning of this month, the European Central Bank president Mario Draghi retained the option of additional long-term refinancing operation programmes at his disposal. It remains to be seen if these will be implemented and we can expect the euro to consolidate in the range between 1.30 and 1.36 against the dollar in the month ahead.
Because of the low interest rates and the flight to safety trade, the Japanese yen will remain strong as the political uncertainty and the risk-off sentiment continues to dominate the markets. In the eventuality of a positive outcome, we can expect an increased flight to equity and consequently, a weaker yen.
The prospects for the Indian rupee have improved as a result of the recent data showing an improving trade balance.
However, in the medium term the dirham-rupee pairing is anticipated to experience considerable volatility in the lead-up to the March 2014 elections. The rupee has reversed some of its losses with the announcement of Raghuram Rajan as the new central bank governor.
Additionally, India’s trade deficit last month narrowed to $6.7 billion, the lowest in 30 months. That has brought some confidence back, at least in the short term. Regardless, political uncertainty in the US will keep the rupee trading in a range of 70 to 75 to the dollar.
Along with Thursday’s debt ceiling vote, perhaps the largest driver of foreign-exchange pricing continues to be the timing of the US Federal Open Market Committee’s proposed tapering of US monetary stimulus.
This was delayed in September (which weakened the US dollar) but markets will continue to remain volatile in anticipation of when this taper will be introduced.
I don’t foresee a taper coming until next year’s first quarter, as the US jobs market is yet to gain enough traction and create enough jobs to justify any easing this year.
Gaurav Kashyap is the head of futures, Alpari Middle East