Fiscal cliff deal paves way for dollar slide

So far, so predictable in the currency markets, with traditional risk-on currencies receiving a boost as stock markets reacted positively to the news that the US fiscal deal was passed by Congress in the early hours of Wednesday morning.

AUD, CAD, NZD, MXN and SEK all powered higher as investors breathed a collective sigh of relief that the prospect of recession in the world’s largest economy might have been avoided. Indeed, only the JPY underperformed the USD as the prospect of aggressive Japanese monetary easing and a renewed desire by the authorities in Tokyo to weaken their currency helped reinforce its funding qualities and drag it lower.

The chance to re-establish risk-on positions also lent support to EURUSD and GBPUSD, but the question remains how long the buoyant mood in the currency market can last?

After all, the reaction to the deal smacked more of relief than confidence in the future. In truth, the deal came later in the day than many would have hoped. The risk-on reaction therefore reflects relief that there was a deal at all, rather than what it contains.

There might have been an agreement in US Congress over tax hikes, but it has delayed negotiations over spending cuts until March 1. Furthermore, tied into those negotiations is the small matter of agreeing to another increase in the US debt ceiling.

As Jane Foley, currency strategist at Rabobank, notes, given the polarized positions of Republicans and Democrats, the odds are that these talks will be difficult.

The market has, in other words, another two months of US budget wrangling to look forward to.

“Even on the assumption that the talks will eventually come to a successful conclusion before the deadline, the uncertainties that these talks will inevitably produce can be expected to be a drag on business confidence,” says Foley.

That would seem to suggest that beyond the short-term euphoria, the recent rise in risk appetite, and corresponding weakness in the USD, and by extension the JPY, might be hard to sustain.

However, others are more optimistic.

BNP Paribas believes that while the deal might appear to be US politicians’ way of “kicking the can” down the road for another two months, on balance it does help to remove the immediate market fears surrounding the US fiscal tightening tipping the US economy back into recession.

The bank says, with its FX positioning analysis suggesting that investors are running light on risk-on positions, the budget deal should provide a catalyst for risk currencies to rally.

Steve Saywell, global head of FX strategy at BNP Paribas, says monetary easing from the Federal Reserve also supports his call for a weaker USD against risk-correlated currencies.

“Furthermore, with the long-term debt outlook for the US not having been improved by the bill, diversification away from the USD by currency reserve managers is likely to put renewed downward pressure on the USD and provide support to the AUD, CAD and also GBP,” adds Saywell.

Steven Englander, global head of FX strategy at Citi, concurs that once the short-term USD weakness on the relief rally in risky assets concludes, there is room for further weakness in the currency.

He says the process of securing the deal was so chaotic and the outcome so unsatisfactory that there is likely to be a further downgrade in US debt at some point.

“The problem is that the fix prevents a sharp near-term macroeconomic hit, but does little on long-term fiscal sustainability, so the long-term impact is likely to be negative on the USD as well,” says Englander.

According to Englander, US credit default swap prices, ratings and government interest rates suggest it would take a downgrade of at least two notches before there is a risk premium added to borrowing costs – and with the Fed prepared to continue to provide stimulus through monetary easing, it might take even more. In those circumstances, he reasons the USD might feel the brunt of the loss of confidence in US finances more than other assets.

“If the political outcome continues to be avoidance of long-term measures and short-term fixes that avoid politically difficult territory, the policy mix of easy fiscal and easy money will remain in place for an extended period,” says Englander.

“Even with somewhat better growth prospects, the policy mix and returns to fixed income, the mainstay of foreign buying of USD assets, remain unattractive.”

So expect the USD to remain under pressure once the relief rally in risky assets has run its course.