Federal budget and EUR/USD

hello,

After heavy negotiations, Republicans and Democrats to come to agreement regarding the federal budget and should be finally approved later this week.

Liquidated be cut worth 63 billion dollars (85 billion from within Sequester).

What is important, and what I wrote in an earlier post <more info> that this plan does not include the extension of unemployment insurance. December 28 expires special aid program in the U.S. for the unemployed. If it is not extended is about 1.3 million unemployed Americans will lose benefits (in the coming months even 800 thousand). A large part of the people in this group may simply abandon the search of job and disappear from the workforce. The result? The decline in the unemployment rate by 0.25% to 0.5%! Of course, this does not mean that the economy will benefit, just the way it works statistics.

The plan is smaller than originally deficit for the next two years (about 23 billion USD), while there will be no tax increases.

EURUSD just rubbed against 1.38 level, despite fairly widespread opinion that 2014 should be the year of the dollar. The question is, why is this happening?

chart 1. EUR/USD & short rate

Responses should look at what is happening in the market interest rate in Europe. Chart at the top (source Bloomberg), shows that the 1M LIBOR for EUR is higher than the U.S. dollar for the first time since March 2012! It also means that since the introduction of the LTRO by the ECB for the first time liquidity in the European interbank market begins "to dry" - something did not foresee the ECB. In addition, Draghi has not helped the whole history to indicate that the ECB currently has no plans to LTRO, and the market also found (although Draghi did not say) that negative rates are not a threat.

Consequently, the German short-term securities are sold out, pulling the short-term interest rate in EUR up, which in turn translates into a strengthening of the euro, as the cash flows to the euro, where deposits are getting higher profitability.

chart 2. EUR/USD & spread GER2Y - US2Y

What's next?

Current situation is not sustainable in the long term. The ECB will not tolerate a lack of liquidity and the increase in market interest in Europe. The question is whether the Bank will be able to offer additional liquidity before the January meeting? American yield will rise after the Fed meeting, but more on the average dates (FRA18x24) and the long end. I believe that normalization of interest in the European market is a prerequisite to ensure that the exchange rate returned to the level suggested by the FRA market (around 1.355 in the medium term and in the longer 1.33).

regards,
oscarjp

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