A pause can be refreshing, but after a while sustained inaction can become downright dangerous. The reflexes slow, the mind numbed by a somnolescence that inhibits proper decision-making. Currency markets in particular, and assets markets more generally, fit this depiction at the present time, but before too long this contented acquiescence will likely morph into something more in tune with the increasingly problematic risks that are gathering in the financial skies around us. Confirmation of this complacency can be found in the VIX index, which fell to a 6yr low on Monday. Unfortunately, very low VIX readings invariably signal a sell-off in risk assets. As is so often the case, identifying the trigger for a reassessment of risk is not a simple task. There are the known issues, such as Europe’s sovereign debt train-wreck and America’s approaching fiscal cliff. In addition, there are the growing tensions in the Middle East, in particular the more hawkish language being used by Israeli politicians towards the nuclear threat posed by Iran. According to the Haaretz newspaper, senior members of the Netanyahu administration are prepared to bomb Iran before the American Presidential election in November. Also, an increasing number of citizens have been purchasing gas masks in Jerusalem over recent days. Nearby, the Syrian administration is clearly unravelling, providing a fresh source of political instability for the region. As is so often the case, September promises to be an interesting, and potentially volatile, month.

Commentary

Looming threats to America’s sovereign rating. Although the various contortions of Europe’s debt crisis will remain a key focus in the final third of 2012, another theme will also occupy the headspace of both traders and investors, namely US fiscal policy. Not much progress on the issue should be expected this side of the US presidential election, to be held on the first Tuesday in November. Indeed, the period of inertia could well extend until at least the end of January when Congress reconvenes. Meanwhile, America is on course for a fourth consecutive year in which the budget deficit is in excess of USD 1trln. Reasonably soon, the thorny question of raising the debt ceiling - currently USD 16.4trln - will again dominate the political centre-stage, a further reminder of the enormous debt burden that America is accumulating. For their part, the three major rating agencies are becoming increasingly agitated at the lack of progress on the fiscal front. Standard & Poor’s, which controversially lowered the country’s rating to AA+ last year, recently remarked that America’s fiscal profile had continued to worsen over the past year. Like many others, S&P remains unsettled by the lack of a credible long-term plan for reining in the deficit, although it acknowledges that last year’s Budget Control Act was a useful first step. The agency is also troubled by overall indebtedness, which from its perspective is near the upper end for the current rating. Fitch appears even more disturbed by recent developments, claiming that the combination of weakening growth and high federal indebtedness represents an urgent risk to the country’s rating. In its latest credit opinion, Moody’s remarked that the rating was under threat because of projected debt ratios and interest costs. Even so, Moody’s did provide some partial reassurance by claiming that any change in America’s rating, if it did occur, would not take place until next year. With fiscal policy likely to be a defining issue over the next few years, it is little wonder that Republican presidential candidate, Mitt Romney, has opted for a fiscal hawk, Paul Ryan, as his running mate. Ryan is the current chairman of the Budget Committee in the House of Representatives and has been the architect of two pieces of ground-breaking budgetary legislation which include huge tax and spending cuts. On the former, Ryan proposes chopping the corporate tax rate from 35% to 25%, and reducing the number of income tax bands from six to just two of 10% and 25%. He also advocates a 10% cull in the number of government sector workers. If the Romney/Ryan ticket gets the vote come November, it might just be that financial markets and the dollar will view this outcome kindly, because the occupant of the White House ‘gets it’ on fiscal policy.

BoE on heightened alert. Yesterday’s MPC Minutes confirmed that members of the committee are on heightened alert regarding the necessity for further stimulus. Interestingly, a cut in the base rate (currently 0.5%) was not discussed apparently, although if this was the case then it is troubling. Although the vote to maintain asset purchases at GBP 375bn was unanimous, it is clear that some members could be convinced to vote for more over coming months should the need arise. Complicating the task somewhat was the announcement that the number of people in work jumped more than 200K in Q2 to 29.5m. London hiring accounted for around half of this gain, helped to some degree by the Olympics. The continuing strength of the labour market over recent quarters - at a time when the economy has been shrinking - remains a puzzle for most commentators. Is it that the growth figures are being understated or that employment has benefitted from a number of one-off factors such as the Jubilee and the Olympics? The latter likely forms part of the explanation, but clearly something else is going on as well, such as preference amongst employers to get people in on a part-time or temporary basis. Interpreting the economic data in coming weeks will not get any easier for the Bank. During the Olympics, for instance, the country was transfixed, which slowed activity and demand in a number of sectors such as retail, construction and manufacturing. At the same time, the flood of tourists arriving into the country has clearly been good news for London. Also, the Jubilee celebrations cut around 0.5 percentage points off growth last quarter, and some of this will be reversed in the current period. As a result, although policy-makers are clearly prepared to act if necessary, more QE from them in the short term is not a fait accompli.