Could the US really default on its debt?

This week has started with some good old fashioned scaremongering surrounding US debt. US Treasury Secretary Geithner said a few days ago that his department is taking “extraordinary measures” to avoid hitting the government’s $14.3 trillion debt ceiling, on which US lawmakers will be voting for a possible rise in a few months.

Members of both the Republican and Democratic parties will be attempting to hammer out a deficit-reduction deal in coming weeks. Ideally this will happen before Aug 2nd, when Geithner claims he will run out of ways to evade a US default!

One worry is that the Republicans will see this as an opportunity to undermine Obama – how far would they be prepared to go in order to bring down the Democratic government? Would they be prepared to block a rise? Thankfully, it looks like Republican House Speaker Boehner is prepared to side with Obama, but how long it takes them to come to an agreement is another problem altogether.

“We could have a worse recession than we already had” said Obama, as he suggested that if the US defaults, then all the dominoes fall. Obama’s statement could be seen as tantamount to blackmail. The US is too big to fail (as was Lehman Brothers), therefore they should be allowed to borrow more – if they do not then the world will suffer a second, larger credit crisis. On the other hand, perhaps these are just the facts of the matter, Obama’s comments do have the support of major think tanks who cite massive job losses , falling stocks and tightened lending as inevitable consequences. Nonetheless, it all seems a bit rich given that Obama himself opposed a similar debt raising proposal back in 2006.

So what would happen with the dollar if the US reached their $14.3trillion debt ceiling?

Well, news from the US can often have an inverted impact on the greenback. Good news means that the world’s largest economy is functioning well; confidence is high and investors leave the dollar in seek of riskier, higher-yielding assets. Bad news from the US spooks the market, and investors chase the safety of the world’s reserve currency- the dollar. So for example when Lehman’s collapsed and triggered a global recession, the dollar appreciated massively as a result. So it is reasonable to expect that a disaster of similar proportions, which Obama asserts is possible, would see the dollar benefit again.

With so much on the line, we’d expect US law-makers to find some sort of solution as it edges closer to the brink, just as we expect eurozone leaders to find a solution to the Greek and Portuguese debt situations this week. The stakes are just too high.

On another note, I recently had an interview with the excellent forexblog – definitely one to follow if you are interested in the money markets.

Senior Analyst – Caxton FX


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