It is obvious by now that the US dollar
has taken a strong hit due to the US government shut-down and political stand-off that placed the country at risk of a technical default.
However, there is reason to believe that dollar weakness is capped.
Many commentators are paying attention to the economic damage posed by the government shutdown. However, the US economy is not tied to government spending to the extent seen in other countries. The private economy holds an immense weight on GDP. As such, the shutdown should not have a lasting impact on economic growth and should only shave a couple of decimal points from the rate of growth.
There are two major issues that seem to have weakened the US dollar, falling investor confidence and delayed expectations for the Federal Reserve's (Fed) 'tapering' of its monthly asset purchases.
First, confidence remains critically important for markets. Stable equity markets throughout the negotiations proved that consumers and investors are used to political bickering. This should mean that consumer confidence affected by political ramifications could easily be recovered.
However, investor confidence in the US dollar as a safe-haven and the world's reserve currency has arguably suffered the most. Foreign investors may diversify their currency holdings because the risk of default became so real.
Nonetheless, this confidence could be recovered with sound fiscal policy and with the Fed's support. Looking forward, the absense of an alternative reserve currency could favor the dollar. While the euro has understandably benefited the most, the Eurozone's economic recovery remains very fragile. Even if the worst of the credit crisis is left behind, the Eurozone still has many structural problems to solve, including high unemployment and lack of a banking union. Also, a high euro exchange rate
does not benefit the region.
The other big setback for the US dollar has been expectations that the Fed will not begin 'tapering' until next year.
These two issues, investor confidence and 'tapering' expectations, have led to a strong bearish trend for the US dollar, especially versus the majors like the euro and the sterling pound.
However, it is difficult to see those trends being sustained, at least for now. Analyst surveys suggest that the market is pricing in tapering to begin next March, a negative scenario that should not be taken for granted.
The US economy remains a major driver of global growth. Coupled with the potential for political and fiscal problems to be resolved with a definitive debt deal, the Fed could resume its tapering plans amidst economic growth.
The above should help the US dollar consolidate and not weaken much further unless it should be confirmed that the Fed's taper plans are pushed further back. The Fed should provide more insight after its two-day monetary policy meeting ends today.