The possible pitfalls in 2023

The US will hit the debt ceiling on January 19^th

^{>> What will drive the US dollar in 2023?}

So far, financial markets have entered 2023 with a spring in their step and it follows the decent end we saw to 2022 after the carnage earlier in the year. But we all know that things can go wrong. However, sometimes bad things can be good for certain assets; none more so than the US dollar.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said when we look out to the possible pitfalls in 2023, there are a couple that immediately come to mind.

The first is the very fractious state of the Japanese bond market. This is something we need to watch closely, and not just for its impact on Japan.

The second immediate threat seems to be coming from the debt ceiling issue in the US. The government will hit the debt ceiling on January 19^th and while this does not automatically mean a host of bad things, like credit downgrades and even default, it does kick off a period of tension until Congress can raise the ceiling again. It has always raised the ceiling in the past and will undoubtedly do so again this time. But we know that the horse trading between Congress and the White House in getting to a debt ceiling deal can be very tense and, in extreme cases, a source of significant angst for financial assets.

This year, perhaps more than most, the stakes seem to be higher. For a start, the Republicans wrested control of the House from the Democrats in the mid-term elections and then, in order to become elected as Speaker, Republican Kevin McCarthy had to cut deals with the far-right Freedom Caucus. These concessions came after some 15 failed votes to elect a speaker.

In the end, it looked as if arm-twisting from former president Trump may have been the factor that put McCarthy into the prized seat, but at a cost that might reveal itself in earnest as debt ceiling discussions intensify and Republicans press for large spending cuts. This will happen pretty quickly because Janet Yellen, the Treasury Secretary suggested late last week that the Treasury’s borrowing capacity could run out in June, creating the prospect of default. Nobody will be anticipating default, and a deal will get done. But that’s cold comfort to the markets for we have seen how this process can lead to financial market strains.

The last time of note was in 2011 and that did lead to a credit rating downgrade for the US as well as the biggest tensions in financial markets since the 2008 global financial crisis. Risk assets, such as equities were put under considerable pressure but the dollar, as is often the case, managed to make good come out of bad as the rise in risk aversion insulated the greenback.

In other words, when bad things happen in the US, they tend to work out well for the dollar. This is because the safe-haven attributes of the dollar tend to overwhelm any national economic or political effects. These effects may be bigger when catastrophe strikes on a global scale, like the financial crisis, or the pandemic, but even adverse events that are very specific to the US can still leave the dollar relatively untouched, or even produce a rally.

>> The US dollar’s peak may be behind us

Will this be the case again if the debt ceiling issue in the US turns very ugly? Mr. Steve Barrow suspects that it will. In short, the dollar has the best chance of rallying this year if things go wrong, and even if they go wrong in the US. For a start, treasury efforts to keep going after January 19^th will likely involve actions that work against the Fed’s efforts to tighten monetary conditions through quantitative tightening. While that will probably not force the Fed to tighten in other ways – through more rate hikes – it does at least show that while debt-ceiling discussions are ongoing, financial conditions could lift the dollar, not lower it. And then there’s the prospect of tighter financial conditions via a rise in global risk aversion should debt discussions get bogged down.

“All the good work of the last few months that has seen bond and stock prices rise could be undone by a debt ceiling impasse and, just as this environment in recent months has seen dollar weakness, so the greenback could recover. In the end, we do not see the debt ceiling situation as an impudent to our call for the dollar to decline through much of this year but it could, at a minimum, just break its fall”, said Mr. Steve Barrow.