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Lesser-Known Facts About Trading the Debt Crisis

Lesser-Known Facts About Trading the Debt Crisis

Kathy Lien, Technical Strategist

It’s important to realize that even the worst-case scenario of a US debt default would be temporary and reversible, so any selloff in the dollar in US assets would likely be limited and easily recoverable.

By now, everyone has heard all about the potentially severe consequences of a US debt default, and for this reason, investors are hopeful that policymakers will at the very least pass a temporary bill to fund the government and raise the debt ceiling for a few more weeks.

Last night, however, President Obama and House Republicans failed to agree on a six-week extension, and according to the National Review's Washington correspondent, it’s possible that a deal is “not as close as many press reports suggest.”

So while we also hope for a stopgap deal that would avoid a spike in market volatility and a sizable selloff in US assets, we feel that it is important for investors to consider what could happen to the US dollar (USD) if the government allows the first-ever US debt default.

US Default Would Just Be Temporary

It is important to understand that if the US defaults on its debt obligations, it would be a temporary technical default. To resolve the situation, politicians just need to put their differences aside and agree to raise the debt ceiling, and eventually, they will.

Still, the historical significance of a default would not be lost on investors, who would sell US assets as soon as the headline hits the wire, and again once rating agencies put the country's sovereign debt rating on selective or restricted default.

However, we do not expect an all-out collapse in the dollar and US Treasuries because the main buyers of Treasuries are central banks, who are less sensitive to short-term changes in the US fiscal outlook. We also don't expect an immediate liquidation out of money market funds.

The Treasury market is still the largest market in the world, and central banks realize that a massive exodus out of Treasuries would cause US bond yields to spike, leading to spillover affects in their own markets.

Technical defaults are not new, especially for emerging market nations such as Peru, whose sovereign debt rating was cut by one notch after defaulting and then restored back to prior levels immediately after the payment was made. If the US were to miss a coupon payment or even two, any downgrades of the US credit rating would likely be reversed once the payments were made.

Dollar Weakness Is Likely to Be Limited

Standard and Poor's downgrade of the US sovereign debt rating for the first time ever in 2011 is also a relevant parallel. The announcement was made on August 5, 2011, a few days after Congress voted to raise the debt ceiling. Almost immediately, investors sold the dollar, but as shown in the chart below, the US Dollar Index dropped by only 1.5%. The currency then consolidated near its lows for a few weeks before rising nearly 8% in the two months that followed.

Guest Commentary: A Past Scenario That’s Worth Studying

Lesser-Known_Facts_About_Trading_the_Debt_Crisis_body_GuestCommentary_KathyLien_October11A.png, Lesser-Known Facts About Trading the Debt Crisis

Losses in USDJPY were a bit steeper and exceeded 2%, and although the price action in EURUSD was choppier, the pair traded in a manner very similar to that of the dollar index, rising only 1.5% before falling more than 9% in the two months that followed.

Essentially, once the initial shock faded, investors realized that there are few alternatives to US Treasuries, so while we expect the dollar to sell off in the event of a US debt default, we do not expect a massive exodus or a 10% collapse.

With all of this in mind, the US government still has options to avoid default. October 17 is the day the Treasury says the US government will run out of cash, but there is a short grace period beyond that, so default is not automatic once this date is reached.

The President could invoke authority under the 14th Amendment and order the federal government to keep borrowing. Desperate times call for desperate measures, and this was a strategy proposed previously by President Clinton during the budget showdown in 2011.

The US government could also sell other assets like gold, or prioritize payment of bondholders over other obligations. While the Treasury has said it does not have this capacity, rating agencies believe otherwise, but prioritization is not a sustainable solution.

Eventually, we expect one party to concede on the Affordable Care Act, and that concession would pave the way for an increase in the debt ceiling. Once that occurs, we expect the dollar to rally strongly.

By Kathy Lien of BK Asset Management

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.