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.