U.S. Debt Plans: What Could Happen to the Dollar?

One week to go before the U.S. debt ceiling deadline on August 2! Is the deficit reduction package ready? According to U.S. House of Representatives Speaker John Boehner, Republicans are planning to push through with their own deficit reduction plan if a compromise isn’t reached soon. Talk about being impatient!

Then again, these lawmakers probably have every reason to rush things especially since they’re keen on avoiding a U.S. debt default. But, as wise men say, only fools rush in. A short-term deficit reduction deal could do more harm to the U.S. economy than good. Coming up with a band-aid fix and simply raising the debt limit could be damaging to financial markets and businesses. It would only be a matter of time until the U.S. finds itself down this road again.

So what can we expect from all this debt debacle? Here are three possible scenarios:

Lift the debt ceiling and pass a deficit-reduction plan

U.S. Treasury Secretary Geithner insists that it’s important for the U.S. to eliminate any possibility of default at least for the next 18 months. It may be a long stretch, but there’s still the chance that U.S. lawmakers could have a “Eureka!” moment and come up with a plan on the eleventh hour.

If the U.S. Congress achieves this feat by approving the deficit reduction plan and raising the debt limit on or before August 2, dollar bulls would have every reason to rally. Not a lot of people are counting on this to happen but, if it does, it could protect the U.S. from getting a downgrade from those credit rating agencies.

Although Moody’s emphasized that raising the debt ceiling wouldn’t guarantee that the U.S. is safe from downgrades, having a solid plan to trim the deficit and avert a debt default could put an end to the U.S. dollar sell-off.

Raise the debt ceiling…for now

After the Gang of 6 Proposal was presented, policymakers thought that perhaps they could raise the debt ceiling just enough to cover the government’s expenses for August.

Mr. Boehner said that borrowing should be boosted by about 1 trillion USD along with spending cuts of almost the same amount. President Obama didn’t like the idea at first, but softened to it soon after. He said that he will support the program if policymakers would pinky swear to a longer-term plan to reduce the country’s whopping 14.3 trillion USD deficit.

A temporary increase in the debt ceiling would probably boost the dollar…temporarily. Sure a default will be avoided and credit rating agencies will have one more reason not to downgrade the U.S.’s debt grade, but investors would soon realize that the country’s debt woes are still there.

No deal whatsoever is reached

The worst-case scenario is for Republicans and Democrats to come to a deadlock and not agree on anything.

If the debt ceiling isn’t increased, credit rating agencies would be forced to downgrade U.S. bonds of their flawless AAA rating. Consequently, credit default swap spreads would increase as investors demand more to hedge for the possibility of a default.

The U.S. has never missed paying its loans, ever. All it takes is one miss and investors would scramble out of U.S. assets including the dollar.

Of course, the Treasury wouldn’t let a default happen so it would probably spend whatever is left in the U.S.’s piggybank to pay for its loans. Consequently, this means that there would be less, or even worse, no money left for Social Security, Medicare, and other services. Yikes!

This debt debacle has been going on for weeks now, and it has taken its toll on the dollar. As you can see in the chart below, the U.S. Dollar index has fallen below support at the rising trend line on the daily chart.

With politicians over at Washington, still nowhere close to reaching an agreement, will we see more downward move for the dollar?

USDX Daily chart

  • PipHur

    There is perhaps also a fourth scenario. Paradoxically, if they fail to reach an agreement, it could very well cause risk aversion among investors, pushing the dollar back up, since traditionally the USD has always been regarded as a safe haven (on a side note, the bond market barely seems to be noticing anything). 

    • Joshua Pearce Gibson

      (Potential) reason why bond markets aren’t noticing: link to babypips.com

  • Debt Advice

    Not a lot of humans are counting on this to appear but, if it does, it could assure the U.S. from accepting a decline from those acclaim rating agencies.