After a week that began with talk of nuclear war and ended with Hurricane Irma, investors are not surprisingly struggling to deal with the deluge of risks that are now confronting them on an almost daily basis, and to price them correctly.
With the summer behind us but with only 10 days of September gone, the challenge of anticipating and calibrating the key factors that will define where markets go through the rest of this year is already immense. Geopolitical risks on the Korean peninsula and natural disasters across large areas of United States and the Caribbean may be at the extreme ends of the scale in terms of what markets usually think about, but it is perhaps no exaggeration to say that the most difficult challenge they face today is in making sense of events in Washington DC and what they will mean for fiscal policy, growth and interest rates.
Perhaps out of the wish to prioritise funds for dealing with the damage caused by Hurricane Harvey, the US president Donald Trump made a surprise intervention into the debt ceiling debate by agreeing to a Democratic Party proposal to extend the US$19.8 trillion debt limit for three months, against the wishes of his own Republican Party and overriding his own Treasury secretary Steve Mnuchen. In the process he has probably created more confusion and uncertainty than he has alleviated, and has aggravated existing concerns about his suitability to be in the White House.
While the avoidance of debt cliff at the end of this month might normally be seen as something to be welcomed, its mere postponement for just three months to the year-end is arguably a much worse scenario for markets and for the economy. Markets would rather get the issue over with now than have it hanging around for the rest of the year. It will only extend the period of uncertainty among investors, corporations and consumers; it will complicate the process of delivering meaningful tax reform; and it will reduce the chances of other key legislation being achieved this year and perhaps even next.
All of this will cast renewed doubt on the outlook for the economy, which also now has severe hurricane damage to deal with, and which will in turn make the job of the Fed much harder when it comes to setting an appropriate level for interest rates. This job had already gotten more complicated by the departure of senior Fed officials, including now its vice chair Stanley Fischer.
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Furthermore, it will probably make worse the already deteriorating relationship between Mr Trump and his own Republican Party, and will cast renewed doubt on his ability to withstand the findings of the Russia investigation which looks set to come to a head in 2018. Overlaying all of this with enormous geopolitical tensions and grave ecological challenges makes the job of pricing these risks very difficult.
With so much noise and uncertainty emanating from the US and especially Washington, it was probably a relief towards the end of week for the markets to be able to focus on a more dependable institution such as the European Central Bank (ECB). Monetary policy setting by the ECB is seldom exciting, and this time it did not have to be as the markets already had enough excitement from events elsewhere. In the event the ECB president Mario Draghi said very little beyond what was known already or was guessed at; that the ECB will set out its plans to end its €60 billion (Dh290.99bn) per month QE stimulus programme next month, and that the euro-zone economy is gathering strength. A nod was made to the problems posed by a strong euro, with a slightly downgraded inflation outlook, but the fact that the ECB appears to be in control of its own destiny with an orderly tapering of QE purchases anticipated was sufficient for the euro to rally.
However, it was the contrast with the uncertainty in the US that was probably the real reason for EUR/USD’s positive response, as the dollar’s weakness is not just a euro phenomenon. EUR/USD strength has more to do with US yields going down, causing broad dollar selling, rather than anything that Mr Draghi said or did not say about monetary policy. And until the US picture becomes less noisy, chaotic and confused it is hard to imagine that the dollar’s predicament is going to change anytime soon.
Tim Fox is Chief Economist and Head of Research at Emirates NBD
