Currency investors should avoid complacency over US debt ceiling
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Currency investors should avoid complacency over US debt ceiling

Many assume politicians in the US will strike a deal over raising the country’s debt ceiling, but there is a danger investors might underestimate the risks of a stalemate.

The US Congressional Budget Office estimates that the Treasury will exhaust all of its borrowing authority between October 22 and 31.

Meanwhile, Jack Lew, Treasury secretary, says the US will run out of cash by October 17 unless the debt ceiling is raised.

In a letter, Lew stated: “We estimate that, at [October 17], the Treasury would have only approximately $30 billion to meet our country’s commitments.

“This amount would be far short of net expenditures on certain days, which can be as high as $60 billion.”

So for the market, there is now a clear date – October 17 – when extraordinary measures are exhausted and the US would risk a default unless the debt ceiling is raised.

The stand-off in Washington shows little sign of coming to an immediate end. House Republicans have argued any hike in the debt ceiling should have conditions attached, such as a delay in funding for Obamacare. The White House, for its part, sharply opposes attaching any conditions to a hike, and has said it will not negotiate on the matter.

Of course, most believe that politicians in the world’s largest country, and which is home to the world’s reserve currency, will eventually strike a deal and set a budget.

In the meantime, however, investor anxiety is likely to rise over a repeat of the August 2011 US debt-ceiling crisis.

Having hit its $14.2 trillion debt ceiling on May 16, 2011, then Treasury secretary Tim Geithner suspended debt issuance and implemented extraordinary measures to continue honouring US debt obligations. These, he said, would fund the US until August 2, when it would have defaulted had Congress not raised the debt ceiling.

After painful political wrangling, a deal was signed that day, but still there was huge market angst before and afterwards.

Indeed, the crisis triggered a 15% collapse in US equities in late July and early August 2011, and resulted in a first sovereign downgrade for the US and loss of its S&P AAA status.

Despite that, however, the dollar index, which tracks its progress against a basket of six leading currencies, held steady during the 2011 crisis.

However, there was a wide-ranging performance among G10 currencies. Traditional safe havens such as the yen and Swiss franc rallied strongly, while risk-sensitive currencies such as the Australian and New Zealand dollars fell hard.

Leading currencies vs US dollar from July 22 to August 12, 2011 (% change)

For many, the repeat of the 2011 wrangling is likely to hit the dollar harder.

“This time around, with the Fed close to a first baby step along the road to policy normalization, the dollar looks more fragile to a debt-ceiling crisis that goes to the wire,” says Tom Levinson, FX strategist at ING Financial Markets.

Indeed, after the Fed’s decision last week to link continued quantitative easing to fiscal policy issues, he views a drawn-out debt-ceiling crisis as a relatively clean dollar negative across the board.

“The dollar index could easily head below 80, with USDJPY and USDCHF vulnerable to ¥96 and SFr0.90 respectively,” says Levinson.

“Only in an unlikely scenario, where the US looks like it might formally default its obligations, might the dollar benefit from safe-haven demand – although even this is uncertain.”

Certainly, the Federal Reserve is conscious of the events of 2011. Just a week after the debt ceiling was raised in August 2011, the central bank adopted date-contingent forward guidance, pledging to hold rates at zero until mid-2013 in a bid to calm global market turmoil.

Indeed, given comments from Ben Bernanke, Fed chairman, that events such as the fiscal stand-off in 2011 could have “very serious consequences” for the US economy, it is perhaps less of a surprise the central bank held back from tapering its asset purchases at its policy meeting last week.

“Assuming a default is avoided, it is the damage to sentiment and activity that will determine whether the Fed tapers in December or later, which in turn has important implications for the likely trigger of independent dollar appreciation,” says Levinson.

For some, the US debt-ceiling issue is the opposite of tapering. Markets were fairly sure that tapering would happen at the Fed’s meeting earlier this month, and were priced accordingly. In the end, they were wrong, triggering a relief rally in risky assets and putting pressure on the dollar.

In contrast, markets are equally sure the US will not default and are priced for a deal being struck.

Admittedly, as the chart below shows, US credit default swap (CDS) prices have risen in recent days, but they are not close to the levels seen during the 2011 crisis.

US CDS prices well below 2011 levels as EM currencies rally

Steve Barrow, head of currency strategy at Standard Bank, says as much as investors should be hopeful over a successful outcome to the wrangling in Washington, they should be concerned over market pricing.

He points out emerging market (EM) currencies – represented in the chart above by the Fed’s Other Important Trade Partner dollar index – can be sensitive to US default risk reflected in CDS prices.

Barrow says bearing in mind how many EM currencies have rallied strongly in the wake of the Fed’s decision not to taper its asset purchases earlier this month, they could be exposed to any surprise failure to reach an agreement on raising the US debt ceiling.

“It is right to assume a benign outcome for the markets,” he says.

“All we’d point out is that current pricing could imply very jittery emerging market currencies if Congress or the White House make one false move.”

Currency investors would be well advised to avoid complacency and keep a close eye on the political shenanigans in Washington during the next few weeks.

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