Foreign Investors Sell Dollars with Debt Showdown Looming
With a debt crisis brewing on both sides of the Atlantic, it is not surprising to see a bit of risk aversion this morning. High yielding currencies have weakened across the board while the U.S. dollar, Swiss Franc and Japanese Yen inched higher. President Obama has given Congress a July 22nd deadline to reach a deal on raising the debt ceiling – any later and there may not have enough time to write and pass legislation before money runs out on August 2nd.
Unfortunately the mere prospect of a debt crisis in U.S. has already scared some investors away from buying dollars. The latest Treasury International Capital flow report showed foreign investors selling dollars for the first time in 11 months. Demand for greenbacks fell by $67.5B in May, which was the first negative print since June 2010 and the largest sale of U.S. dollars since July 2009. There was some demand for long term U.S. Treasuries, but short term securities was sold for the seventh month in a row. The lack of demand for short term assets reflects concern about the U.S. government’s ability to repay short term liabilities. Given little progress made on raising the debt ceiling between May and July, there is a reasonable chance investors continued to bail out of U.S. dollars. There was also a large negative change in the foreign liabilities of U.S. customers managed by U.S. banks or broker dealers that contributed to overall decline in Treasury International Capital flows. Long term TIC flows rose by $23.6B in May, but this was the smallest increase since Jan 2010.
Although China has pressured the U.S. to protect the interest of its investors, they remained net buyers of U.S. dollars. Russia on the other hand continued to put their money where their mouth is – they have been talking about diversifying out of dollars and into euros for months and even though they have sold dollars gradually in recent months, they stepped up the pace in May. Luxembourg was also a big seller and given the country’s tax haven status, the outflow should be a reflection of European investors moving money out of U.S. dollars and into Swiss Francs – a behavior that has probably continued in June and July.
U.S. Debt Showdown
The debt showdown in Washington will be the market’s biggest focus this week. However as we get closer to the August 2nd deadline to increase the debt ceiling, rating agencies and investors alike are starting to realize how bad things can get if the ceiling is not increased. Two of the top rating agencies in the world have already warned that they will strip the U.S. of its prized AAA rating if the debt ceiling is not increased over the next 2 weeks. China, the U.S.’ largest creditor called on the U.S. to protect the interest of its investors because they also realize that a ratings downgrade can have a cataclysmic effect on the U.S. dollar and in turn the value of their portfolio. With a little more than 2 weeks to go before the U.S. Treasury runs out of money and effectively defaults on their debt, the clock is ticking. Unfortunately Republicans and Democrats can’t seem to reach an agreement on anything outside of the fact that they are running out of time. The U.S. government must raise the debt ceiling by August 2 nd or face dire consequences.
Let me tell you how bad things can get if the debt ceiling is not increased. The U.S. has never had anything but a AAA rating and this is the single biggest reason why the U.S. dollar is seen as a safe haven currency. Investors know that no matter how uncertain the global economy may be, U.S. Treasuries are the safest in the world because the U.S. government has never missed a debt payment. It is this flight to quality that has kept U.S. interest rates low and the economy supported. If the U.S. were to lose its AAA rating, foreign investors would start to question the security of U.S. Treasuries and some investors such as China will start to reduce their holdings which would in turn drive U.S. yields higher. With such an anemic recovery, the U.S. government and the American people will not be able to handle higher borrowing costs. Stocks would also fall significantly as investors shun U.S. assets and worry that higher yields could eat into profitability. This is a slippery slope scenario that the U.S. government cannot risk falling into and thankfully the one thing Republicans and Democrats agree on is that the consequences would be very severe. In fact, Standard & Poor’s put the chance of a downgrade at 50 percent which means they believe there is a one in two chance that the U.S. debt ceiling will not be increased in time. Monetary policy alone gives investors very little reason to own dollars and a downgrade would take away the only reason which is safe haven.
The Republicans have until Saturday to tell President Obama whether any of the 3 options he proposed to trim the budget would win GOP support. Their choices are:
a) $4 Trillion deficit reduction deal that includes raising taxes and cutting entitlement programs
b) $2 Trillion deficit reduction package
c) Much smaller package that would raise the debt ceiling but include no tax increases or cuts to entitlement programs
A back up plan proposed by Republican Senator from Kentucky could also be a viable solution – his plan includes raising the debt limit in 3 stages, totaling $2.5 trillion by next summer – this plan is quickly becoming the most likely option even though it doesn’t directly address the issue. It only buys the U.S. government time until the economy recovers and tax receipts are significant enough to cover part of the deficit. It doesn’t take much to avoid Armageddon – everyone just has to put their political agendas aside and raise the debt ceiling – which we think is likely to happen.
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- Debt Ceiling Impasse is Killing the Dollar, No Support from Data
