HiFX's Dan Bell looks at US fiscal cliff doomsday and best case scenarios and the NZ dollar's declining volatility

Here's our weekly currencies outlook and review with HiFX's Senior Dealer Dan Bell including a look at best and worst case US fiscal cliff scenarios, and the New Zealand dollar's waning volatility.

No sooner had Barack Obama been re-elected US President on November 6 than traders and investors in the world's financial markets started fretting about the so-called fiscal cliff his country's economy, the world's biggest, faces in 2013. The fiscal cliff, which refers to about US$607 billion in automatic tax increases and spending cuts set to take effect next year, could cut 4 percentage points off US gross domestic product next year, force unemployment up a percentage point - or by about two million jobs, and send the US into recession, according to the Congressional Budget Office.

Given this investors were nervous due to the stark divisions between the Obama led Democrats and Republicans, who control the US House of Representatives. In a nutshell the Republicans don't want to raise taxes and Obama has pledged to not extend President Bush era tax cuts for wealthy Americans. On top of this spending cuts agreed as part of last year's debt ceiling deal will begin to take effect next year. See the fiscal cliff explained here.

But with Americans more focused on Thanksgiving this week than fiscal matters, concerns over the impending fiscal cliff have eased, even though Federal Reserve Chairman Ben Bernanke warned failure to reach an agreement could send the US economy “toppling back into recession." Bell says it's hard to see why people are more relaxed when there hasn't been any material developments to suggest a compromise between Democrats and Republicans.

"There's about US$600 billion in tax cuts and government spending which will be taken out of the economy so it's a particularly significant development for the US economy," says Bell.

"I think perhaps people are thinking it would be crazy for them not to sort it out because we've seen that the US Congressional Office, the equivalent of our Treasury, has suggested that it would throw the US economy back into a major recession in the first-half of next year so why would you do that?"

"Until we get a resolution on that I think you will see the markets trade with a little bit more caution over the next few weeks," Bell says.

Worst case scenario: 10% fall in global stock prices

As for a worst case scenario if the two sides can't agree: "At this stage with the global economy still so fragile I think we'd see a 10% drop in global stocks and I think we'd see a 5% to 10% drop in the New Zealand dollar simply on the basis of risk aversion across the board."

"It would be a major risk aversion moment and it's obviously something that we don't need right now. The US economy, as some have been highlighting, is starting to show some better signs," says Bell. This highlighting includes by Bernanke who said this week a plan for resolving the US’s longer-term budgetary issues without harming its economic recovery could help make 2013 a very good year for the US economy.

And if the Democrats and Republicans can thrash out a fiscal cliff deal, Bell suggests this would be a net positive for the New Zealand dollar.

"Because it would be positive for risk sentiment and the Kiwi continues to trade with a positive correlation to that, although not quite as tightly as it once did. I think it would be positive for global growth expectations, risk sentiment, and on that basis the New Zealand dollar would find some more upside momentum, I believe, against the US dollar, Japanese yen and probably most of the European currencies."

Earlier this month Bell said HiFX's technical analyst believed the New Zealand dollar had potential to rise as high as US88 cents (it was at about US81.62c this afternoon), which would be back up at its post 1985 float high reached on August 1 last year. However, this week he was reluctant to "put US88 cents out there."

"(But) realistically if we do get through the fiscal cliff, if the first-half of next year is a bit more positive, then the New Zealand dollar could easily maintain an uptrend back up towards US84c to US85c."

Annual NZ dollar volatility halves

Separately, Bell points out the New Zealand dollar has been a lot less volatile this year, against the greenback, than in the past few years. For 2012 so far it has traded between US74.50c and US84.50c. That compares with a range of US71.10c to US88.40c in 2011.

"For the calendar year the New Zealand dollar versus the US dollar has had a range of about 12%. The previous year it was 25%, the year before that it was about 22%, and the year before that, during the middle of the global financial crisis, it was running at about 40%," says Bell. "So to be at 12% this year is quite a significant drop from what we've seen over the last few years."

"I think that's reflective of the significant liquidity (trillions of US dollars, euros, yen and British pounds) pumped into the global financial system from the central banks that has brought down the level of anxiety and volatility."

"In fact the implied volatility that is priced in the market for the New Zealand dollar against the US dollar in the options market is at its lowest in over 10 years," adds Bell. "That's basically investors pricing in the implied volatility of the New Zealand dollar over the next three, six, nine and 12 months. That implied volatility is very, very low at the moment so again investors are looking at next year and considering this lower volatility will prevail for some time."

This view could, of course, come unhinged if US politicians can't resolve their fiscal cliff differences or the Euro-zone comes a cropper.

On the latter, Eurozone finance ministers are expected to approve the next tranche of Greece's bailout funds- around €44 billion - next week. And back in the US, where budget deficits have exceeded US$1 trillion in each of the last four years pushing the country's debt above US$16 trillion, if the politicians can avoid a plunge of the fiscal cliff, their heads may crash into the debt ceiling once again, with this expected to be hit again at some point in the first quarter of 2013.

Currently set at US$16.4 trillion after a US$2.4 trillion increase in 2011, the debt ceiling is the maximum amount the US government can borrow.

----------------------------------------------------------------------------

To subscribe to our free daily Currency Rate Sheet and News email, enter your email address here.

----------------------------------------------------------------------------

Dan Bell is the Senior Dealer at HiFX, a UK-headquartered foreign exchange dealer with significant operations in Australia and New Zealand. It has a dealing room in Auckland. See more detail here.