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US Federal Debt Ceiling: Moody’s Downgrade Shows How to Trade It

By , Quantitative Strategist
28 July 2011 00:45 GMT

The US Debt Ceiling represents a key risk to financial markets, but what does it mean for currencies and how can we trade it?

Legislative deadlock threatens to place the US Treasury in a form of default as a key deadline approaches. The US Treasury has the constitutional right to issue bonds in order to finance government budget deficits. The Treasury is granted effective autonomy with one clear exception: Congress mandates a maximum level of Treasury debt outstanding at any one time.

The Treasury hit its mandated debt limit as of mid-May and has been unable to issue fresh net debt since it hit its maximum. Officials estimate that the Treasury could become insolvent by August 2nd, as there are substantial payments due to entitlement programs on August 3. If August 3rd arrives without the debt limit being raised, we can expect risky high-yield assets, such as Australian Dollar, Norwegian Krone, and stock markets to drop dramatically, while “safer” low yielding assets like the Japanese Yen and Swiss Franc jump. We also expect that market volatility in coming weeks will be high as traders react to any news of progress or failure in debt ceiling negotiations.

US Federal Debt Ceiling, in Trillions of Dollars

US_Federal_Debt_Ceiling_Moodys_Downgrade_Shows_How_to_Trade_It_body_Chart_2.png, US Federal Debt Ceiling: Moody’s Downgrade Shows How to Trade It

What’s the Risk?

The US maintains the top sovereign credit rating from all major rating agencies, and recent rallies in Treasury bond prices emphasize that global demand for US debt remains strong. Thus the act of raising the debt ceiling should be a mere formality, consistent with the fact that Congress has raised it 11 times in the past 10 years.

Yet this time seems different. Political deadlock suggests that Congress could actually let the Treasury’s solvency deadline pass without a deal in place. And though it is impossible to predict how all markets would react to such an event, it’s fairly clear that it could be disastrous for a wide range of assets.

What could happen if the Treasury Defaulted on its Debt?

The effects of a Treasury default would be substantial and far-reaching, leaving few corners of the market untouched. US Treasury Debt has long been recognized as the global risk-free asset. In most financial models, returns in any asset are benchmarked against the equivalent risk-free rate.

The US government bond yield is thus the bare minimum return required for any US Dollar-denominated asset. If the government defaults on its debt, no matter for how short a period of time, Treasury debt prices would fall sharply and yields move quickly higher.

The yield on owning stocks would have to rise, prices fall to account for the higher underlying benchmark risk. This could easily force the broader US S&P 500 lower and force contagion across international financial centers. We could see a global sell-off in financial market ‘risk’.

In fact, we got a preview of what might happen as Moody’s downgraded outlook on the US sovereign credit rating on July 13th. The US Dollar sold off sharply as an immediate reaction, but the bigger moves came from the S&P 500 and the forex carry trade.

S&P 500 Futures Prices Drop Significantly as Moody’s Downgrades US Credit Rating Outlook

US_Federal_Debt_Ceiling_Moodys_Downgrade_Shows_How_to_Trade_It_body_DebtCeiling_1.png, US Federal Debt Ceiling: Moody’s Downgrade Shows How to Trade It

Source: DailyFX.com

The US Dollar reaction was slightly more nuanced, as the Greenback initially sold off sharply only to recover shortly thereafter. We could envision similar reactions from the US Dollar if the Debt Ceiling is not raised ahead of the August 2 deadline.

Dow Jones FXCM Dollar Index (Ticker: USDOLLAR) Tumbles on Moody’s US Credit Rating Outlook Downgrade but Subsequently Bounces

US_Federal_Debt_Ceiling_Moodys_Downgrade_Shows_How_to_Trade_It_body_DebtCeiling_2.png, US Federal Debt Ceiling: Moody’s Downgrade Shows How to Trade It

Source: DailyFX.com

Short-term interest rates serve as a great predictor of how currencies would react to further debt ceiling concerns. Currencies with higher interest rates are expected to fall, while low-yielders rise.

G10 Currencies Ranked by 3-Month Deposit Rate

US_Federal_Debt_Ceiling_Moodys_Downgrade_Shows_How_to_Trade_It_body_Picture_8.png, US Federal Debt Ceiling: Moody’s Downgrade Shows How to Trade It

Interest rate differentials predicted the Australian Dollar/Japanese Yen reaction quite clearly, as the pair tumbled following Moody’s announcement.

Australian Dollar Tumbles Versus Japanese Yen on Moody’s US Credit Rating Outlook Downgrade

US_Federal_Debt_Ceiling_Moodys_Downgrade_Shows_How_to_Trade_It_body_DebtCeiling_3.png, US Federal Debt Ceiling: Moody’s Downgrade Shows How to Trade It

Source: DailyFX.com

What do we watch for?

It will be critical to watch various political happenings within the US Congress going forward. Who are the key actors?

The President: US President Barack Obama has taken the spotlight on the debt ceiling issue, pressing legislators on both sides to agree to substantial cuts in spending while raising tax revenues from the wealthiest groups in the country. Facing re-election in 2012, the President is well aware that any missteps could cost him his job and has accordingly put a great deal of pressure on his own party and the opposition to strike a deal.

Republicans: The Republicans hold the majority of seats in the House of Representatives and any deal on the debt ceiling would require significant Republican support to pass. The issue at hand is the fact that the conservatives are seeking substantial spending cuts in return for their vote—larger than the actual increase in the existing debt ceiling.

Republicans are very much opposed to new taxes, and the run-up to 2012 elections virtually guarantees that many will cling to their anti-tax bias as they face their constituents for re-election in just over a year.

Democrats: On the flipside, the Democratic Party has much at stake as it takes a tough stance on taxes and entitlement spending. Those on the left are strongly opposed to aggressive cuts to popular Social Security and Medicare programs. The Democrats see real risk that any significant concessions could cost them the majority in the Senate and perhaps the presidency in 2012.

Both sides are clearly entrenched in their respective ideologies with much at risk ahead of an election year.

The stalemate could create further market tensions as the August 2 deadline approaches. Yet you would not guess as much if US Treasury bond prices are to be believed. The 2-Year Treasury Note yield is near record lows (meaning that the bond price is near record highs) as traders show little concern over the imminent debt ceiling deadline.

US Treasury 2-Year Note Yield Drops Near Record Lows on Robust Demand

US_Federal_Debt_Ceiling_Moodys_Downgrade_Shows_How_to_Trade_It_body_Picture_10.png, US Federal Debt Ceiling: Moody’s Downgrade Shows How to Trade It

Source: Bloomberg

Moody’s Downgrade Serves as Preview of What Could Happen if Congress Fails to Act

The Moody’s US Credit Rating Outlook downgrade served as a small-scale preview on how markets could react to a US Treasury default if Congress fails to act on the Debt Ceiling. Watch this key risk going forward, as we are likely to see substantial volatility on Congressional inaction. The fact that markets are pricing in a low risk of default only enhances the risk of reaction in the markets.

Written by David Rodríguez, Quantitative Strategist for DailyFX.com.

To contact the author of this report, e-mail drodriguez@dailyfx.com. To be added to the author’s e-mail distribution list, send an e-mail with title line “Distribution List” to drodriguez@dailyfx.com

Key Politicians who Could Move Markets

US_Federal_Debt_Ceiling_Moodys_Downgrade_Shows_How_to_Trade_It_body_Picture_11.png, US Federal Debt Ceiling: Moody’s Downgrade Shows How to Trade It

US President Barack Obama (D):

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Representative John Boehner (R) , Speaker of the House:

US_Federal_Debt_Ceiling_Moodys_Downgrade_Shows_How_to_Trade_It_body_Picture_13.png, US Federal Debt Ceiling: Moody’s Downgrade Shows How to Trade It

Representative Eric Cantor (R), House Majority Leader:

US_Federal_Debt_Ceiling_Moodys_Downgrade_Shows_How_to_Trade_It_body_Picture_14.png, US Federal Debt Ceiling: Moody’s Downgrade Shows How to Trade It

Senator Mitch McConnell (R), Senate Minority Leader

US_Federal_Debt_Ceiling_Moodys_Downgrade_Shows_How_to_Trade_It_body_Picture_15.png, US Federal Debt Ceiling: Moody’s Downgrade Shows How to Trade It

Senator Harry Reid (D), Senate Majority Leader

US_Federal_Debt_Ceiling_Moodys_Downgrade_Shows_How_to_Trade_It_body_Picture_16.png, US Federal Debt Ceiling: Moody’s Downgrade Shows How to Trade It

Representative Nancy Pelosi (D), House Minority Leader

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28 July 2011 00:45 GMT