Tensions hold back US Fed

If I were to ask a colleague how the US dollar reacted to the above, chances are the answer would be as follows: the dollar has become stronger. And that is a logical answer. The US dollar has long been seen as a safe haven in difficult times. It is clear that times are difficult at the moment. 

And yet the dollar has weakened considerably recently, despite the large amount of geopolitical unrest. The EUR/USD is now slightly above 1,20. That is the highest level since the spring of 2015. 

The market was presented with an opportunity in which the Fed would raise rates as many as 31 times between now and December 2018, 4. The question now is no longer whether the ECB will follow that route, but when the bank will start restricting European monetary policy. The ECB board will meet again next week and this topic will certainly be discussed. 

Government shutdown
And then there's the impending one date of September 29, the day when the US government will reach the debt ceiling. This means that if Parliament does not raise the ceiling before then, the US government will no longer be able to make payments. This is called a 'government shutdown'. 

That is not new, because a shutdown has happened before. However, this time it is a bit different. It would not be surprising if Washington can no longer meet its financial obligation to investors. This includes interest payments on the national debt and the redemption of maturing government bonds. 

That in turn means that the United States is, formally speaking, bankrupt at that point. Some credit rating agencies have already warned that the US rating will be downgraded in the near future as a result of this situation. 

Greater chance of bankruptcy
Why is the chance of bankruptcy greater this time? Because President Donald Trump does not appear to have any intention of cooperating with parliament. He will go into it with both legs straight. At least, if parliament does not agree to some of his other demands, such as the construction of the wall between the United States and Mexico. He then wants to allow the debt ceiling to be reached. 

In short: plenty of reasons for the dollar to fall in value. And yet, based on the past, you would expect that tensions would slow that decline somewhat. This is because the dollar is normally a safe haven. However, this does not seem to be the case at the moment. 

Of course, the Fed is not concerned about all this. Tensions between North Korea and the US do not appear to be going away anytime soon. In itself, this is no reason not to increase interest rates, but if there were not other factors at play. 

Interest rate increases on hold
The chances of Trump's promised large-scale tax cuts and infrastructure investments are diminishing by the day. This is important because those investments would promote the growth of the American economy. And that would also increase inflation, which is a reason for the Fed to raise interest rates further. 

Now that it looks very likely that those investments will not materialize, it would not be surprising if the market becomes less likely to see a series of rate hikes from the Fed. In the meantime, the ECB will already start phasing out 'quantitative easing' in the euro country, especially now that economic growth in the euro zone appears to be higher. 

Relationship with White House
The relationship between the White House and parliament in Washington does not seem to be getting any better either. That increases the risk of disasters, such as not raising the debt ceiling. This may in time also have consequences for another potential source of tension and unrest: namely the question of whether Trump will retain current Fed Chair Janet Yellen. Her term expires soon and so the president will have to make a choice quickly.

If Yellen is left behind, the market may see that as a defeat for the president. After all, during the election campaign he clearly stated that he would dismiss Yellen. If Yellen remains in place, the market will know that the Fed will continue to be led in the coming years by someone who is not eager to tighten monetary policy. 

In short: US official interest rates may rise very slowly with Yellen in the coming years.

EURIBOR in hibernation
If a replacement for Yellen is appointed, the market will face uncertainty: what cloth is the new Fed boss made of and how will the rest of the board react? Will any members resign? Who will be the replacements? It will take at least a few months before that becomes clear.

All of the above seems to indicate that the Fed will raise rates more slowly than investors expect. If the ECB indeed continues to restrict monetary policy, this could have significant consequences for EUR/USD.

However, beware: as I have emphasized in the past, the ECB cannot deviate too much from the path set by the Fed. If the Fed slowly increases the official interest rate in the US, the ECB will not be able to do anything too crazy in the monetary field.