Time is running out for lawmakers to reach an agreement on the US debt ceiling, with the possibility of a possible sovereign default likely having implications for the US dollar.
The greenback has been in a slump for more than seven months, weighed down by signs of a slowing US economy and the prospect that the Federal Reserve will soon suspend rate hikes and even cut borrowing costs.
The ICE US Dollar Index
DXY
is down almost 11 percent since the end of September last year. Now Treasury Secretary Janet Yellen is warning that a US debt default would have an “adverse impact” on the dollar’s role as a reserve currency, a scenario that has been widely speculated and dismissed by many.
Read: Big question when the dollar comes under fire from competing countries and currencies: what happens to the markets when the greenback loses its dominance?
The FX market remained relatively quiet around the clock on Tuesday, along with US stock and bond markets, as traders and investors await Wednesday’s April CPI update.
So far, concerns about the debt ceiling have largely been confined to the short-dated Treasury bill market, but that could be changing. Currency volatility could increase as inflation data is due and as the US debt ceiling debate “further fuels traders’ concerns,” said Daniel Takieddine, Dubai-based head of Middle East/North Africa region at global financial services firm BDSwiss.
“Each successive episode of the debt ceiling drama has investors and officials from around the world looking at the US and concerned about its credibility and reserve status,” said Tom Nakamura, currency strategist and co-head of fixed income at AGF Investments in Toronto, which had $31.6 billion (CAD$42.3 billion) under management as of April 30. “Yellen is right about the potential impact on the dollar and even taking the negotiation to the end would marginally erode confidence in the US.”
The concerns unfolding behind the scenes in financial markets are compounded by the apparent lack of progress in Washington. President Joe Biden will host a much-anticipated meeting with the country’s top four lawmakers on the US debt ceiling around 4 p.m. Eastern time Tuesday. However, analysts do not expect a deal just yet.
Meanwhile, Yellen is personally calling chief executives to explain the “catastrophic” impact a US default would have on the US and global economy, Reuters said, citing two sources familiar with the matter.
The Treasury Department is likely to run out of opportunities to operate below the $31.4 trillion legal borrowing limit as early as June 1. The main point of contention between Republicans and Democrats is whether spending cuts should be tied to an agreement. Republicans want spending cuts in exchange for raising the federal debt ceiling, while Biden and other Democrats oppose and support a “clean” debt ceiling hike.
Lauren Henderson, an economist at Stifel, Nicolaus & Co. in Chicago, said her firm still expects the dollar to remain the dominant currency “but that requires Congress to pass an increase in the debt ceiling.” The continued uncertainty “puts pressure on our dollar, which is already being weighed down by other countries beginning to break away from dollar dominance,” such as Russia and China.
Should the US default on its debt, the immediate reaction in financial markets would be “dollar negative,” AGF Investments’ Nakamura said over the phone. Other currencies – be it the euro or the Swiss franc – or even commodities like gold “are likely to benefit quite a bit.”
For the Treasury market, meanwhile, there would be a “mixed picture,” he said. Investors and traders would add risk premiums and raise interest rates on T-bills and the 2-year note
TMUBMUSD02Y
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partially offset by traders theoretically pricing in more aggressive rate cuts by the Fed as well. According to Nakamura, European rates markets should outperform along with the other G-10 rates markets. It remains to be seen whether high-quality corporate bonds will be viewed as a good alternative to Treasuries, which would help keep credit spreads contained.
Major US stock indices on Tuesday
DJIA
SPX
COMP
were mostly lower in afternoon trade as fed funds futures traders priced in a 79 percent chance the Fed will hold interest rates steady in June and a 21 percent chance of another quarter-point hike next month. Meanwhile, the US Dollar Index traded around 101.62, down from nearly 114.11 on September 27, while US Treasury yields were little changed and mostly higher.
Yellen’s comments Monday about the impact a government default could have on the dollar “consistent with what Fed Chair Jerome Powell said at his press briefing last week” that the Federal Reserve is unlikely to be able to would be to insulate the economy from the damage caused by a failure to raise the debt ceiling, according to Marc Chandler, managing director and chief markets strategist at Bannockburn Global Forex in New York.
“If the US defaults, it would speed up the process that people have been talking about in terms of the dollar’s role in the global economy and only speed up the process of the US being perceived as in decline,” Chandler said over the phone . “It could do lasting damage to America’s reputation and appeal, and our opponents would take full advantage of that.”
The medium- to longer-term impact of the current debt ceiling issues is difficult to quantify, but would likely exert longer-term downward pressure on the US dollar as market confidence erodes, AGF Investments’ Nakamura said. In theory, this would also put upward pressure on government bond yields as investors sell government bonds, although it is not yet clear how much and how quickly this will affect yields, he said.
“The market still thinks this is a tightrope act, which we’ve seen before, so we’ll see if we can get an extension through the fall,” Nakamura said. However, “there are some construction concerns that will likely continue to grow over the next few weeks unless there is a coming together of the two sides or they can kick the can out in the street.” If we get into the last week of May with no action, that concern is likely to increase.”
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