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Foreign Exchange

US debt deal won’t save dollar, says JPMorgan

A draft agreement on raising the US debt ceiling will not be enough to shift a bearish outlook for the dollar, say analysts at JPMorgan. The US dollar is trading lower against most pairs following the deal announcement, and in trade-weighted terms is actually down 0.2% against a basket of currencies since Friday’s close, JPM calculates.

Republican and Democrat leaders have agreed on a deal to raise the debt limit by an initial $900 billion, with spending cuts worth $917 billion. A special congressional committee has been charged with finding a further $1.5 trillion in savings by the end of 2011, Citi strategists report. Crucially, the deal is not set to be re-negotiated until 2013 – taking president Barack Obama through next year’s presidential elections without further re-opening negotiations.

USDJPY briefly hit 78.04 when the deal was announced, but fast money sellers pounced soon afterwards, Citi reports. The dollar is already tracing Friday’s low at 76.70, and drifting towards its all-time low of 76.25.

The weakness of the dollar’s brief overnight rally shouldn’t come as a surprise, JPM strategist John Normand says. Earlier this month, the bank warned that any agreed rise in the debt ceiling would only be positive for the dollar under two conditions: if short US dollar positioning (near record levels) had been used solely to hedge default risk, or if Congress included a second Homeland Investment Act in its agreement.

Such an act would aim to repatriate earnings of US companies from abroad. Though much discussed in recent weeks, there was no mention of an HIA proposal in the draft Congressional agreement.

Still worse for the dollar, Normand argues that present short positioning suggests a bearish attitude to US fiscal tightening. The bank argues that slashing spending will be seen as a proxy to monetary tightening by the Federal Reserve, keeping dollar yields low for years to come.

Spending cuts are likely to weigh on GDP growth beyond 2012, JPM says. Last Friday’s second-quarter results show that the US economy is growing at an annualised rate of 1.3%, well below the Fed’s forecast of 3.5-4%. Q1 GDP was also revised down from 1.9% to just 0.4% annualised. Expectations of a rate hike have now been pushed back to Q4 2012, with the possibility of further quantitative easing now likely.

Further issues are looming for the US, says Normand. There is a possibility of an immediate downgrade if ratings agencies consider the debt deal too unambitious, with potentially huge ramifications for currency volatilities should they do so. More fundamentally, the bank questions whether Washington’s political machinations are permanently damaging the dollar.

Medium-term, the Swiss franc and the yen are the most obvious beneficiaries, as the most liquid G10 dollar alternatives, says JPM. Trading in most dollar pairings is likely to remain rangebound during August.

“We stick with range structures rather than directional risk even after Sunday's announcement, and will be looking to re-enter shorts in USD/JPY, USD/CHF and EUR/CHF,” Normand concludes.

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