How will US debt ceiling disputes impact USD?

White House Press Secretary Jen Psaki at the White House on Oct. 4. 

Of course, it never does that, and it probably won’t this time either. But do these crises events chip away at the US’s standing, and particularly that of the dollar?

The USD28.4tr debt limit  expired in August and, since then, the US Treasury has been using “emergency measures” to get around the problem, but its capacity to do this will run out around October 18th according to Treasury Secretary Yellen. If Congress has not increased or suspended the debt limit  by then the Treasury will have to choose who not to pay, meaning agencies, contractors and more, while prioritising interest payments to avoid a default.

In theory, if the impasse goes on long enough even interest payments could become impossible to pay. Nobody thinks we will get to this point but it is worth noting that during the August 2011 debt ceiling showdown S&P still downgraded the US’s sovereign rating by one notch, even though the government still paid its dues to creditors. 2011 was not the only debt ceiling crisis; there were tensions when Bill Clinton was president in 1995 and 96 and again in 2013. The 2013 crisis prompted the Fed to simulate the impact of a one-month period where the debt limit  binds borrowing authority. It concluded that 10-year yields would rise 80-bps, the dollar would fall 10% and stocks would crater by 30%. And, just for good measure, there would be a two-quarter recession.

Now clearly, we don’t know if that’s anything like correct or whether it could be any sort of template for what might happen now. While there have been times in the past when the crisis has weighed on stocks, such as 2011 after the debt downgrade, the dollar has not really floundered. In the 2011 episode, it was quite stable against other major currencies through to the early August downgrade and then actually started to rally later in the month. The problem, as we know, in trying to calibrate any impact is that the risk of a default seems undeniably bad for the dollar, but any surge in general risk aversion will likely lift the currency.

Many might question whether the dollar can really be considered “safe” when the government is on the brink of default, but Mr.Steve Barrow, Head of Standard Bank G10 Strategy suspected that the dollar would probably only fall against some of the other major currencies such as the yen, Swiss franc and possibly the euro. It would likely rise elsewhere and especially against emerging market currencies.

But besides any short-term consequences of near default, are there longer-term costs to the dollar. In other words, the dollar might rise against riskier currencies in the heat of the debt-ceiling battle, but could it essentially lose the war over the long-term as the market vents its frustration over these periodic, and some would say idiotic, bouts of debt wrangling. For instance, in the past, debt ceiling disputes have often been caused because one Party wants to extract concessions from the other and uses debt-ceiling skulduggery as leverage. But, in today’s spat that’s not even the case. It simply seems that the Republicans don’t want to vote to lift the ceiling whatever the Democrats may offer in return. Similarly, the Democrats don’t want to use their majority in Congress to lift the ceiling as they argue it covers spending already made by the prior Trump administration. Frustration over this issue has led some to suggest novel solutions, such as evoking the Treasury’s ability to mint coins (presumably for commemorative purposes) to make a USD1tr coin that can be deposited at the Fed.

“The Treasury would then be able to spend against this deposit without borrowing. Of course, this won’t happen but, in revealing the level of exasperation about this issue it might just be a sign that the US is playing fast and loose with investors’ confidence in treasuries and the dollar. Over time we think this could cost the dollar, but only moderately and not in the heat of the battle”, Mr.Steve Barrow stressed.