Citi On The "Disastrous" USD Implications From A Debt Ceiling Breach

Tyler Durden's picture

Much has been speculated about what the possible impact on the fixed income market may be if the debt ceiling is breached. Few, however, have wondered about the impact of what the lack of a debt ceiling resolution would be on a market that one could argue is even more important: FX. Citi's chief currency strategist Stephen Englander takes a preliminary look at the implications of what this would look like. Englander admits that "a breach of the credit ceiling is priced in neither fixed income nor FX markets to any significant degree now", and proceeds to speculated that it is foreign exposure (recall that China has over $4 trillion in foreign financial assets) that would be most impacted by such an adverse development. To wit: "Our expectation is that the FX reaction to a
debt ceiling breach would be sharper and probably more permanent that
the FI reaction, because unhedged foreign investors will see another
layer of risk that can not be 'fixed' in the way that cash flows from
Treasuries can.
The FX market reaction may not be catastrophic, given
the limit to the fixed income damage that is likely to be permitted to
emerge, but it would legitimately tax foreign investor patience and lead
to further USD dumping whenever the opportunity arises.
" Bottom line: the race to the garbage bottom between the USD, EUR and JPY continues in earnest, with nobody yet a solid favorite to win, er, lose first.

From Citi's Stephen Englander:

We argue below that the impact of a debt ceiling breach may be larger and more permanent on the dollar than on fixed income markets.  So it is worth going through the analysis, even though the dollar has so many immediate problems that it seems unnecessarily rude to bring up a problem that may not emerge for another couple of months.
We are not predicting (and certainly not recommending) a debt ceiling breach. What we are trying to assess is how such a breach might play out in fixed income and foreign exchange markets.
A breach of the credit ceiling is priced in neither fixed income nor FX markets to any significant degree now. Even two months ago there was a virtual consensus that a debt ceiling breach would be an unmitigated disaster for US asset markets. Confidence in Treasuries as the ultimate safe haven would be destroyed and there would very likely be spillovers into other asset markets. If investors or business were counting on using coupons or redemptions to meet obligations, there would also be the possibility of a series of business or investors defaults tied to delayed Treasury payments.
The revisionist view is that a breach of the debt ceiling would magnificently concentrate the minds of Congress and the Administration to reach a speedy deal on longer-term fiscal consolidation. In this view, if brinksmanship or even a few days delay in receiving a payment were the cost of long-term reform, it would be worth it. Longer-term attractiveness of Treasuries might even be enhanced if the deficit were put on a sustainable course.
What intensifies the risk is that Congress and investors may be coming to see policymakers as wearing a safety harness as they jump off the debt ceiling cliff. If the financial market reaction is too negative, Congress can have a quick session of mutual recrimination and quickly vote a debt ceiling increase. If policymakers convince themselves that the consequences are reparable they are more likely to take risks. Statistically, there is greater willingness to do bungee jumps than suicide leaps, although very rarely one unexpectedly turns into the other.
We would like to raise the possibility that the impact of a debt ceiling breach could easily fall more on the USD than on fixed income markets.  The reason is that unhedged foreign investors in Treasures will not be wearing the safety harness that domestic fixed income investors might be,  and may see their losses as having much higher risk of being permanent. 
First, consider how the optimists see a breach playing out on short- and medium-term fixed income Treasury securities. Unless an extended breach is expected, many domestic investors will see buying opportunities on any drop in fixed income prices. If the expectation is that a back up of yields would lead to a quick lifting of the debt ceiling, then many investors would see the higher yields as a buying opportunity. Coupons will be paid and any delay quickly made up.
Given how much unused credit there is, one could easily see financial institutions lining up to give loans on the back of Treasury collateral. So businesses and investors that needed the money would be able to borrow on or sell off possibly technically defaulted Treasury collateral.
The perspective of unhedged foreign investors, with currency risk, likely will be much less benign. Many of the arguments in favor of a debt ceiling breach reflect the extremely small probability that Treasury owners will be out significantly in a cash flow sense from such an event. 
Foreign investors will see 1) an additional unwanted tool of macro policy added to an already impressive array of non-orthodox policies; 2) another US policy debate that entirely centers on US domestic political convenience and ignores the interests of foreign investors; 3) confirmation that US policymakers favor policy options that will almost inevitably weaken the dollar, even while swearing up and down that they adhere to a strong dollar policy and are simply targeting domestic objectives. (You are about as likely to see a Higgs boson smiling out of your morning coffee as find an instance where the US policymakers of either party made a policy move intended to strengthen the dollar.  See the recent essay by Buiter and Rabhari: "The ‘Strong Dollar’ Policy of the US: Alice-in-Wonderland Semantics vs. Economic Reality on the strong dollar policy."  )
Most importantly, 4) while a domestic bond investor can be made whole in a cash flow sense with virtual certainty, there is no way that unhedged foreign investors can be guaranteed that any FX market reaction will be unwound similarly. Domestic investors may have some reason to see themselves doing as doing a bungee jump, but foreign investors are not sure whether the tension limit is set for 200 feet above the ground or 15 feet below.
In practice foreign and domestic investors in USD assets tend to have different perspectives, Our expectation is that the FX reaction to a debt ceiling breach would be sharper and probably more permanent that the FI reaction, because unhedged foreign investors will see another layer of risk that can not be 'fixed' in the way that cash flows from Treasuries can. The FX market reaction may not be catastrophic, given the limit to the fixed income damage that is likely to be permitted to emerge, but it would legitimately tax foreign investor patience and lead to further USD dumping whenever the opportunity arises. 

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TooBearish's picture

Debt ceiling breached this week - like a tree falling in the forest - not a sound.....

slaughterer's picture

Of course, the USD will collapse if the debt ceiling is breached...  this is common sense.  But what is going to happen to the EUR in the meantime?

Al Gorerhythm's picture

like a tree falling in the forest - not a sound.....

like steam rising from Fukushima - not a sound.....

Al Gorerhythm's picture

Past demands by voters for entitlements from future governments, puts the debt ceiling at $76 trillion, give or take. Now where in the world (literally) will that money come from?

What to do, what to do?


dolly madison's picture

"Past demands by voters for entitlements from future governments"

Not to mention ridiculously high military spending for way too many years.

Catullus's picture

Geithner needed a scare-mongering report from Wall Street to support his "Raise the Debt Ceilling or the world will end" tripe. Took a new level with this one.  Even thinking about not raising the debt ceiling could trigger loss of confidence in the US dollar.... Ooops.  I've said too much.  But obviously China would hurt the most, no one else.  There is absolutely no reason to interpret my warning as a reason to sell US or European banking stocks. By the way, this is absolutely not priced in whatsoever and everyone on the planet has been ingoring the massive deficigt the US government is running up and the nearly daily articles coming out everywhere.

GFORCE's picture

Definitely a race to the bottom. Just like the market rallying after Lehman went down, we'll look back on some of these events and wonder why it was brushed aside.


overmedicatedundersexed's picture

think logically and you's all good news and taking ES higher FRN's are here to stay..buddy can you spare a  pre 1964 dime?

spanish inquisition's picture

The same private owners who own the USD, EURO & YEN central banks will continue to manage them in a range bound area between each other. So, if the debt ceiling is breached, I think they still have a few short term tricks up their sleeves to keep all the currencies viable and in the prescribed ranges.

The question is which one would you sacrifice to save the other 2?

Urban Redneck's picture

Stephen Englander is Geithner's little sock puppet.  The issue that Englander is debating is not the significance of breaching the debt ceiling- it is the significance of missing a payment to bondholders.  THE DEBT CEILING HAS ALREADY BEEN BREACHED.  The US government is already under obligation to repay the funds it has been "borrowing" from government pensions to finance operations, which would put it over the Congressionally-Suggested-Borrowing-Limit.  The obligation simply isn't "counted" towards the debt because of the FASB FRAUD that allows public (government) accounting to make bank accounting look honest.  Too silently allow Englander to use deceptive wording like this implies consent to the underlying lie. 

White.Star.Line's picture

A hardcore opiate addict who is given keys to the pharmacy, will not worry about silly "ceilings" either.

It is easy to figure out how this is going to end.

bigdumbnugly's picture

Tyler, can you do this in video with a horse race backdrop?  Maybe have a few sway-back nags moping along and falling over every few furlongs?

trav7777's picture

it's all a bunch of imaginary confetti...maybe they're afraid the debt above ceiling will be repudiated as illegal lol

mayhem_korner's picture

Translation: don't take away my I.V. of Ben's clownbux, or else I'll be found out for the fraud that I am.

grunk's picture

This may be just a lonely banker's pathetic cry for maid service.

slaughterer's picture

American Maid-raping Psycho, Part 3

pupton's picture

So what can the little guy do to protect his modest wealth from this impending disaster??? I saw Ron Paul on TV (CNBS) a few minutes ago and he said(because they asked him) that the US has maybe two or three years left before a final collapse. Is hoarding silver the answer? I have some silver and guns and ammo and even a six month supply of food. I'm worried because I have two young kids that if TSHTF they will grow up in a mad max world.

DeltaDawn's picture

Teach your children skills, up it to 1 year's of food.

mattwett12's picture

Teach them basic survival skills like making fire from sticks and rocks, hunting, and shelter building.

But seriously, hoarding a metal has significant risks does it not? The "little guy" generally does not have a market to trade precious metals on? (Maybe i'm horribly wrong.)

I think hoarding a 6 month supply of food is a little extreme.

White.Star.Line's picture

Having ONLY a six month supply of food on hand is a bigger "significant risk" than metals investment returns.

HEHEHE's picture

Other than precious metals the USD as a currency has much more going for it in the short to intermediate term than the EUR and JPY.  At some point the PIIGs are going to sink the Euro or those countries will be kicked out of the Euro zone.  The tsunami and resulting damage likely whacked a at least five-10 years off the fuse of Japan's demographic time bomb explosion.  The USD, even as overridden with debt as we are, still has more road to kick the can down.  I'd say give the Euro 3-5 yrs until demise, JPY 5-7,  US 10-12, with several crises during those periods.

In about 10 years we'll be back on the gold standard.  Otherwise there'll likely be a world war.  Also do not believe the Yuan will ever be the world's reserve currency.  Their books are cooked as much as the EUR, JPY, and USD.

TK69's picture

The sovereign debt is a big joke. It is just a smoke screen to give the illusion of a monetary limit.  In actuality, there is no limit to what they can spend.  It is all artificially created.  There are no actual transactions between sovereign currency conversions, just a book entries at central reserve banks.  And foreign currency, for the most part, stays in it's issuing country because of legal tender laws.  And this means that the US, like the world, is just printing it's own money under the illusion of debt.  It is a ponzi scheme of epic proportions.

HungrySeagull's picture

I don't give a shiti what Citi has to say.

The United States has required a bigger and bigger injection since 1T deficiet. The next injection of debt will only poke a dying horse which is past caring about the pain.