3 Numbers To Watch: US Credit Ratings, Fed Presidents, FX Carrys

After the deal in Washington D.C. that temporarily avoided the default, raised the debt ceiling and re-started the government, eyes are now on the coming avalanche of previously postponed economic data.

The first one to come out is probably September’s employment report, which could be published early next week. Another driver will be the timing of the Federal Reserve’s tapering of its asset purchase programmes — the market consensus sees January as the earliest point, but the next meeting is already on October 30. The third driver will sooner or later be the outlook for the next round of negotiations in Washington D.C.: budget negotiations have to start before the holidays and government spending under the current deal is funded until January 15 and the debt limit is suspended until February 7. It is not hard to see a wall of worry ruining Christmas.

The Leading Economic Index for September from the Conference Board will not be published today due to the delays caused by the shutdown. The only major data point is the Canadian inflation number, which will be of limited interest to the markets, so I'll write about some current themes of interest.

US Credit ratings
Right before the can of debt was kicked to next year, the credit rating agency Fitch decided to put the US long-term AAA-rating on ‘rating watch negative’, according to Reuters. This means that the agency expects to decide on a possible downgrade during the first quarter of 2014. Fitch specifically said that the length of a possible agreement is one of the factors in its coming decision, and the agreement is a very short one. The less-known but aspiring Chinese agency Dagong downgraded US by one notch from A to A- yesterday, even though the deal was already confirmed at that time.

During the previous brinkmanship on the debt ceiling in 2011, the credit rating agency Standard & Poor’s downgraded US from AAA to AA+, four days after the debt ceiling had already been hiked. The credit raters have received a lot of criticism for their role in the financial crisis. It is thus understandable that when they see something that cannot be accepted, they will point it out — even to the US. We should soon start to see headlines and rumours of the other rating agencies moving in — namely, Standard & Poor’s and Moody’s.

If all goes well, the stern warnings from the agencies are understood by the congress, and the debt ceiling is abolished or its hiking is made automatic based on the budget (see Washington Post’s article on ‘Gephardt’s rule’). On the other hand, it is also possible that the early part of the 2014 will see the US with a worse credit rating and the gridlocked government — with a central bank that has basically printed its quota full.

Central bankers speaking
Today we have a long list of central bankers speaking. The Federal Reserve’s speakers will be on stage late in the European evening, but perhaps Charles Evans will have a word or two on tapering (all times GMT).

06:35 Bank of Japan, governor Haruhiko Kuroda

16:30 Federal Reserve, Daniel Tarullo (dove, FOMC non-voter) Fed conference on resolution of systemically important banks

18:00 Federal Reserve, Charles Evans (dove, FOMC voter) At FMA Annual Meeting Luncheon.

19:40 Federal Reserve William Dudley (dove, FOMC voter) Fed conference on resolution of systemically important banks.

20:30 Federal Reserve Jeremy Stein (dovish, FOMC voter) On “Methods for Addressing Financial Imbalances”, at the NBER’s conference “Lessons from the Financial Crisis for Monetary Policy”.

EURUSD: interest rate differentials
The interest rate differentials between any two currencies are one of the most well-known and consistent drivers of exchange rates. The currency with the higher nominal interest rate tends to appreciate in value against the currency with a lower interest rate. This creates a profit opportunity for investors both from the interest rate differential and the exchange rate.

The chart below shows the difference between the yields of the two-year government notes of both US and Germany. A number of 0.15 percent thus means that the US note has a slightly higher yield than the German note. The local peaks of the spot exchange rate have been associated with a relatively low interest rate differential, while the local troughs have been associated with relatively high rate differential.

Unfortunately, other factors often break up these patterns. EURUSD’s downtrend in August is a good example of this. Even though the differential had only risen to 0.19 percent, a bad US employment report made the exchange rate turn around, and the surprise “no taper”-decision from the Fed, the government shutdown and the near-miss of a technical default led to higher exchange rates.

The current interest rate differential is around 0.12 percent, which has previously been a level to sell the EURUSD. Perhaps after the ECB talks the pair down a bit, the negotiations in the US proceed well and tapering is again back on agenda the pair could be in for quick reversal? But before that moment, the dollar is not in demand. Besides, the interest rate differential might very well be on its way to even lower levels, which would remove any caps that have been keeping the EURUSD rangebound. See also Mads Koefoed’s post on Saxo Bank’s FX carry trade strategy. Marc to Market-blog had a nice but a bit dated related chart.