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US Federal Debt Ceiling Threatens Forex Markets - How do we Trade It?

US Federal Debt Ceiling Threatens Forex Markets - How do we Trade It?

2011-07-01 16:35:00
Krishna Yarra,
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The European debt crisis has threatened the very existence of the Euro, but the United States has had its own potentially cataclysmic event lying in the weeds: the potential of a default if the debt ceiling is not raised by August 2. If such an outcome occurs, the most profitable positions to take would be long gold, long Swiss Franc against currencies such as the Australian Dollar, New Zealand Dollar, and Canadian Dollar.

The prospect of a default by the United States would destabilize the global economy. With both political parties deeply entrenched in their respective doctrines, and the Euro-crisis temporarily put on hold, the market’s collective eye is now set to fixate itself on the debt crisis evolving in the United States.

Since the U.S. Dollar is widely considered to be the world’s reserve currency, the American government has been able to finance a deficit by issuing more debt. The US Treasury is granted authority by Congress to issue as much debt as needed to fund government operations as long as the total debt does not exceed a stated ceiling.

Over time, however, Congress has felt it prudent to raise the debt limit whenever it would be breached. In fact, since 1981, the ceiling has been raised a total of 22 times. Now, however, a combination of geopolitical factors and domestic political issues have rendered a stalemate on the debt ceiling battle with both sides of the American political spectrum drawing proverbial lines in the sand and refusing to budge.

US_Federal_Debt_Ceiling_Threatens_Forex_Markets_body_Chart_4.png, US Federal Debt Ceiling Threatens Forex Markets - How do we Trade It?

With Republicans controlling the House of Representatives, one of two chambers of the US Congress, it’s clear that the Democratic leadership would not have the votes to raise the debt limit on its own. On one side, Republicans (conservatives) refuse to raise taxes while Democrats (liberals) stand tough against aggressive cuts in spending.

As the markets watched, the May 19, 2011 deadline to raise the debt ceiling came and went with the Republican Party sticking to their word. Now the question was no longer whether or not the debt ceiling would be raised but instead what the government needed to do in order to remain solvent and not default on its obligations.

If a decision is not reached by August 2, the United States federal government would find itself unable to shore up the funds to pay back its debt. While some academics have speculated that the Federal Reserve, as a scenario of last resorts, could initiate emergency measures in order to prevent a default, it is widely accepted that an inability to reach an agreement by August would signal the inability of the U.S. government to repay their lenders.

The effects of this default would be far reaching, and to an extent, unknown. Across the world, U.S. Treasuries are considered a “risk-free” asset, such to the point that the yields on Treasury bonds are the “no-risk” returns that investor performances are benchmarked against. Since an event such as this would be completely unprecedented, the effects on the global markets can only be hypothesized.

Yield on 10 Yr. US Treasury Bonds from 2003 to Present

US_Federal_Debt_Ceiling_Threatens_Forex_Markets_body_10_yr.png, US Federal Debt Ceiling Threatens Forex Markets - How do we Trade It?

The short-term health of all US Dollar-based pairs would erode quickly and their long-term health would be called into question as the Greenback and treasuries would plummet in value. It is hard to say which asset class investors would pile into as the Dollar and US sovereign fixed income securities have been the traditional “risk-off” plays. It is possible that the USD/CHF pair would fall significantly, but a better currency cross would most likely be XAU/USD, or more commonly, Gold.

In other words, the savvy investor who believes that an agreement won’t be reached by August will buy Gold and lots of it, as the precious metal has been the historical global safe haven from risk.

Weekly Chart of Gold Prices from 2010-Present

US_Federal_Debt_Ceiling_Threatens_Forex_Markets_body_gold.png, US Federal Debt Ceiling Threatens Forex Markets - How do we Trade It?

Furthermore, markets would shift to the “risk-off” mode for an extended period of time, quite possibly years. Equity indices could plummet as well as the risk currencies, the Australian Dollar, the Canadian Dollar and the New Zealand Dollar (also referred to as the commodity currencies).

Shorting the AUD/CHF pair or NZD/CHF pair, and possibly even the EUR/CHF pair would most likely be actionable trade ideas in such a situation. Additionally, the grim outlook for the US economy could transfer over to its neighbors to the north and south and the Canadian Dollar and Mexican Peso would also likely be hurt, given the strong links between the export industries of the North American economies.

Shorting the MXN and CAD relative to the Swiss Franc could prove profitable. Using currencies as a hedge against the potential risk of a default by the U.S. government could greatly insulate traders from the potentially devastating losses by equity and fixed income markets.

Written by Krishna Yarra, DailyFX Research Team

To contact the author of this report, e-mail research@dailyfx.com

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

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