What To Expect From This Week's Dollar

The focus this morning for the forex market is on the euro and rightfully so given this weekend's German elections and this morning's euro-zone PMI reports. Economic activity in the euro zone accelerated in the month of September, fueling hope that the region is poised for a stronger recovery that could bridge the gap between the European Central Bank and Federal Reserve's monetary policies. However today PMI numbers were mixed with manufacturing activity slowing and with the decision by the Fed not to taper last week, it will be a long time before ECB and Fed policies are aligned. There's not much in the way of U.S. data this week but that's does not preclude the potential for dollar driven volatility for the forex market.

Fed Speak
To start, we have a number of U.S. policymakers scheduled to speak this week and their comments could continue to shape the market's expectations for Fed tapering. Today alone, Fed Presidents Lockhart, Dudley and Fisher will be talking but of these three gentlemen Dudley was the only one to vote at last week's FOMC meeting. He is generally more dovish than his peers so it will be interesting to see if he also believes that the central bank could reduce asset purchases this year. Last week, we heard from FOMC voters George and Bullard and both seem to support a reduction in 2013. George said she actually dissented from the last decision and criticized the central bank for not following through with its signals to the market, saying that it erodes their intent of policy, creating confusion and disconnect. Bullard did not slam the Fed's actions but he made it clear that the Fed could still taper as early as October. He said the decision this month was a close one and since the central bank did not feel that $10 billion is a big deal, they decided to just forgo the move. The main takeaway from their comments is that a reduction in asset purchases before the end of the year is still on table and this could limit the losses and maybe even prop up the dollar this week. We will be watching the heavy Fed speak calendar to see if their peers at the central bank share George and Bullard's views.

Washington's Budget Standstill
The main risk for the dollar this week will be the ongoing developments in Washington. The House ended last week by passing a stopgap spending boll that would fund the government until the end of the year but it would also withhold all funds for Obamacare. This was widely viewed as the first shot fired in what will undoubtedly be a contentious and long battle in Washington over raising the debt ceiling. With only eight days to go before the government runs out of cash, the stakes are high as large parts of the government could be shut down on October 1 and this poses the risk of the first ever U.S. default. We've been down this road before and an extension or deal has been reached every single time. The stakes are high and the debate will be contentious but we believe that at the end of the day, the impact on the dollar should be small. The last time the government was shut down was between 1995 and 1996 and during this time, the dollar index dropped less than 1%. Of course, if politicians cannot put their differences aside and reach a compromise, the financial markets and the dollar could be big trouble but we think that this unlikely as an 11th-hour deal will most likely be reached.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management .