US debt ceiling and impacts on USD

US Treasury Secretary Yellen has left few in any doubt that the dollar’s global status (and presumably its value) would be undermined by a default.

While there’s been a lot written about the possibility of a technical default, we don’t believe that this will happen for one second. But that does not necessarily mean that risk assets will be able to rally. In 2011, the US narrowly avoided a default but riskier assets, such as stocks, were still pummelled as S&P stripped the US of its AAA rating. We do not expect another downgrade this time but we do think that the impasse could cause some considerable nerves in the market in coming weeks and so leave quite an imprint on asset prices.

Indeed, it seems very possible that financial markets will mete out their own ‘justice’ before X-day (when the government’s cash runs out) if the politicians cannot find a solution quickly. This sort of market tension might actually be needed to remind politicians of the risks they are running by letting the clock tick down.

What sorts of tensions could arise? Clearly, we’ve already seen some minor pressures in terms of things like the rise in the yields of relatively short-dated Treasury bills, or in shorter-dated CDS prices. But looking ahead we are really thinking in terms of the more significant market dislocation that could come from a more general rout in treasuries, a slump in equity prices, surging asset price volatility and perhaps even dollar funding and liquidity strains. If financial markets experience such tumult on fears that a solution to the debt ceiling problem might not come in time, how would the dollar react?

US Treasury Secretary Yellen has left few in any doubt that the dollar’s global status (and presumably its value) would be undermined by a default. A near-default, which is what we are talking about, might be expected to do some harm, if not on the scale of a technical default. But, as we’ve seen before, when bad things happen, even in the US, the dollar can rally on account of its safe-asset status.

Could this happen again even if the very safety of this safe-asset is bought into question by near-default? It is possible, but our sympathies lie more in the direction of dollar weakness, certainly against other perceived ‘safe’ currencies such as the yen, the Swiss franc and probably the euro. The reason we take this view is down to the fact that the Fed and other central banks will be quick to supply dollar liquidity if any sort of dollar shortage issue arises because of funding strains. We saw back in March during the initial strains in Silicon Valley Bank and CSFB how the Fed was very quick to bolster its ability to supply dollars to other central banks.

On that occasion, it increased the frequency of its dollar swap operations via other major central banks from weekly to daily. In the event, take-up was quite low as no major dollar funding strains emerged and, as we know, this was reflected in the fact that the dollar fell quite heavily through this period. If the debt ceiling issue were to create similar concerns, we’ve little doubt that the Fed would step up again and, as long as it arrests any potential dollar funding problems, we should find that the dollar depreciates, rather than appreciates.

However, what happens when the crisis is over? Would any dollar weakness on a near-default be reversed once the politicians manage to avert – or postpone – a full-blown debt crisis? Mr. Steve Barrow, Head of Standard Bank G10 Strategy doesn’t believe so. In the end, there’s probably going to be no winners from this crisis, either in terms of the political parties, the economy, or the financial markets – and that includes the dollar.