FX Update: Difficult terrain for USD ahead on US debt ceiling crunch time.

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Today's Global Market Quick Take: Europe from the Saxo Strategy Team

FX Trading focus: A difficult terrain ahead as debt ceiling crunch time approaches. RBA set for big structural changes.

The House Republicans came up with a complete non-starter of a budget bill that Senate Democrats will never pass, much less the veto-holding Biden administration. The bill looks to raise the debt limit by $1.5 trillion and reduce some $130 billion in spending next year, including axing many of the Biden administration’s hallmark initiatives, like canceling student debt and some of the climate- related programs (although details can be hammered out later). House speaker McCarthy claimed that the bill could save the government $4.5 trillion over the next decade. The House Republicans would have to show extreme discipline to get it passed even in the house as it can’t pass if they lose more than four votes from 222 possible.

What to do with the US dollar then? On the one hand, liquidity headwinds lie ahead and threaten risk sentiment headwinds and possibly USD upside. These come from the Fed continuing its QT while the US Treasury is set to drive a net liquidity drain from here. (Backgrounder: US treasury has been providing extensive liquidity as it drained hundreds of billions of USD from its account at the Fed. That account has now dwindled to about as low as it can go now, stopping that source of liquidity for now. And once the debt limit issue is cleared, the Treasury will set about rebuilding the account by hundreds of billions, driving even tighter liquidity.) But if the Biden administration and Congressional Republicans play a game of brinksmanship, it’s hard to imagine that process as a USD positive and will keep the Fed in a cautious stance. The situation could come to a head as soon as early June because of weaker than expected tax revenues, while otherwise late July has been considered the more likely pinch point at which time the US Treasury runs out of room with its special maneuvers. If sanity prevails and a handful of Republican House members cross the line, the issue can be avoided until possibly 2025, if the “Problem Solvers” caucus discussed in this article can get an alternative passed.

Sterling failed to get much out of yesterday’s hot CPI print, even as 2-year UK swap rates jumped 15 basis points on the news. GBPUSD couldn’t convincingly challenge the 1.2500 resistance again despite the yield spread widening to new extremes for the cycle. At present, the market is pricing BoE rates to be 25 basis points above Fed rates by year end. This is already difficult to swallow, much less any significant extension of the difference. Driving GBPUSD more than a figure or so higher at this point in the cycle would likely require some major US debt-limit related incident requiring eventual Fed liquidity injection. Expecting sterling to ramp higher because the BoE is finally getting more inflation-fighting religion is far less likely. EURGBP is back in the middle of the range it has traded within all year – still a non-story, though upside is likely the side of least resistance. GBPNOK has my contrarian warning lights flashing…

Chart: AUDNZD
While we await for something to give in either direction in the major USD pairs, the relative merits of AUD and NZD are worth consideration here after the kiwi was knocked lower in the wake of a lower than expected inflation number for Q1 at 1.2% QoQ and 6.7% YoY vs. 1.5%/6.9% expected, respectively and vs. 7.2% the prior quarter. This capped NZ yields and lowers the odds of a May rate hike from the RBNZ. From here, if inflation reheats, the RBA will have more work to do than the RBNZ to fight inflation. Meanwhile, an economic slowdown scenario would leave. With China’s economic activity picking up is normally an added potential benefit for the Aussie, although the key commodity prices coincident to that story are not offering much support to that story. See below for more on the RBA, which is set for a changed structure and meeting frequency that brings it into line with global peers. Next steps for firmly shifting focus back to the upside would be clearing the 200-day moving average and 1.1000 area.