Currency
Forex
September 4, 2023
3
min read
The Debt Ceiling and the Dollar
There has never been a default by the US government, so there is no precedent to gauge the potential outcome. It is safe to assume that the consequences for financial markets, including forex, will be chaotic and destructive.
Bill Henner

Markets are still assuming that a deal will be reached. Here are the likely implications for the dollar if the US defaults (even temporarily) on its obligations.

The debt ceiling crisis has dominated headlines for the past several weeks. The deadline (June 1, according to Treasury Secretary Janet Yellen) is fast approaching, and markets will closely follow developments, with volatile reactions likely to any good or bad news from the negotiations. Technically, the ceiling has already been reached, but the Department of the Treasury has been employing “extraordinary measures” to allow the US to keep paying its bills. Financial markets have yet to exhibit extreme volatility, evidence that they believe that a solution will be reached in time. However, the calmness is unlikely to persist as the deadline approaches. Secretary Yellen has said, “Failure to meet the government’s obligations would cause irreparable harm to the U.S. economy, the livelihoods of all Americans, and global financial stability.”

What happens if the US fails to raise the debt ceiling?

Short-Term Implications for the Dollar:

  • Dollar weakens: A loss of confidence in the US will almost certainly have negative consequences for the US dollar. The dollar has maintained its role as a store of value because it is viewed as a safe investment. Investors are likely to reduce dollar holdings if that perception changes.
  • Higher interest rates. Investors will demand higher rates of interest to hold US government debt. Yields have already spiked on short-term interest rates. On Monday, 1 month US treasury bills were yielding 5.7%, up from less than 4.4% on May 1. 
  • Global financial chaos: Stock markets around the world would sell off. Investors hate uncertainty; the normal reaction is to dump risk assets like equities. 

Long-Term Implications for the Dollar:

  • Structurally weaker dollar. The world would adapt to a new normal in which the dollar is no longer considered a risk-free asset. A natural premium has always been paid for that safety, which would be eroded by the world’s loss of confidence in the dollar.
  • Higher borrowing costs for the US government. Because of the dollar’s reserve currency status, the US has enjoyed lower interest rates than most other countries. A global move away from dollars would increase the interest rates investors demand to hold US paper (bonds and bills).
  • Disruption of the global economy: Most international transactions are priced in dollars. The scramble to find an alternative would result in chaotic markets and disorderly pricing of essential commodities. That could lead to serious consequences for countries that rely on commodity exports as a source of revenue as well as countries that import raw materials.
  • Huge Losses on dollar holdings: Countries holding large dollar reserves, such as China and Japan, would suffer significant losses. Many other countries would be similarly affected.

Clearly, a default on the US national debt would have widespread effects on the entire world. It is a nightmare scenario that would affect every country around the globe. Currently, markets are behaving as if a solution is imminent. Global stock markets are firm, with US equities near the year's high. That could change very quickly if there is not a timely resolution. Economists have warned that there could be a run on the dollar that would look like SVB (Silicon Valley Bank) on steroids. Global equity markets could plummet in an event resembling the Crash of 1987. The outcome could be a global great depression.

“Creative Solutions” Are Unlikely to Work

Recently, there has been talk of ways the executive branch could circumvent the need for Congress to raise the debt ceiling. The two most commonly discussed proposals are:

  1. Minting a trillion-dollar “coin”                                           

The US treasury technically has the ability to issue platinum coins of any denomination. In theory the treasury could mint a $1 trillion coin and deposit it at the Federal Reserve. This would essentially give the government $1 trillion that could be used to pay obligations. Any attempt to do this would undoubtedly be challenged in court. The ensuing litigation could delay implementation of the plan, rendering it ineffective.

  1. Using the 14th Amendment to raise the debt ceiling by executive order.

The 14th Amendment to the Constitution states “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.” Proponents say this means that the executive branch could use this as justification to unilaterally raise the debt ceiling. This action would also be challenged in court, delaying what would need to be a quick response. Many argue that it would also set a precedent that could have dire consequences in the future.

 Takeaways:

  • Even if Congress raises the debt ceiling before June 1, some damage has been done to the world’s confidence in the dollar. This will likely hasten the process of de-dollarization that is already occurring in the global financial system.
  • In 2011,  Standard & Poor's stripped the US of its AAA credit rating, even though a default was averted. A similar downgrade of US debt may occur this time. A lower debt rating means it will cost more to borrow in the future.
  • The cost of insuring against a US default has risen dramatically. Credit default swaps on US debt are now more expensive than similar swaps on the debt of Greece, Mexico, or Brazil.

The only reasonable solution is for both sides to agree to lift the debt ceiling. Anything else will create unimaginable chaos. As mentioned above, the world’s financial markets are proceeding with the assumption that there will be a timely agreement. The hope is that pragmatism will win out over partisanship.

Treasurers, financial teams, and risk managers should be prepared for any event, no matter how unlikely. Forex volatility will likely rise from current low levels, so companies should assess their risks and take appropriate measures to protect themselves from adverse movement.

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