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Dollar Faces the Market’s Judgment on a S&P Downgrade to AA+ Monday

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Daily Forex Market News and Analysis
Dollar Faces the Market’s Judgment on a S&P Downgrade to AA+ Monday
By John Kicklighter, Currency Strategist
06 August 2011 06:04 GMT

Though the dollar was already trading under heavy fundamental waves through the past week; the coming week will likely see the swells turn into a tidal waves wave starting with Monday’s Asian open. With the backdrop already roiled by a building global financial crisis; US market conditions took a serious turn for the worst after the close on Friday. Initially starting out as an unconfirmed headline from an unnamed source, we learned that credit rating agency Standard & Poor’s took the unprecedented step of downgrading the United States. The country’s AAA status has stood as the primary attraction for the nation’s assets for decades. This shift has deep-rooted implications for the US and its currency; but its impact is far from clear. With market stability already coming unhinged due to second round effects from the previous Great Recession and Financial Crisis; the shock this development delivers the market can take many different forms.

The most rudimentary interpretation of this after-hours announcement is that global investors will simply abandon US Treasuries and dollar in mass to avoid the speculative crush that could theoretically hit come Monday’s open. However, the reality is not so clear-cut. It is impossible to say how sentiment will settle among the masses to this news; but two things are certain: general confusion will create severe volatility and the gradual effort to diversify away from the US currency as the only viable reserve currency will accelerate. The first thing FX traders should be concerned about though is the immediate, first-impression reaction. As the weekend wears on, impromptu policy meetings will be called to strategize on a crisis response and prevention. It wouldn’t be too far a stretch to expect a coordinated effort amongst global powers to stabilize the world’s (not just the United States’) credit market and exchange rates. Europe will be particularly interested in the former consideration while Japan and Switzerland will pull immediate focus to the latter (more on that below).

When it comes down to it, this move was not unexpected. The deficit reduction plan that was approved by Congress and signed into law by President Obama just this past Tuesday (cutting it down to the wire) primarily helped by raising the legal deficit ceiling while providing very little in the way of a solid plan to reign in the massive debt load over the next decade. The rationale that Standard & Poor’s gave for its downgrade made reference to the government’s use of this problem as a bargaining chip and its flimsy solution. That said, Treasury officials and banks were already discussing contingency plans and seeking waivers for Treasury holdings well before the deadline was reached. A prominent concern in this situation is that many funds are prohibited by charter or agreements to hold anything rated less than AAA. If they cannot obtain authorization to hold their Treasuries; they will be forced to sell. Inevitably, some groups will not find permission.

In the meantime, we have to remember that we are still in the midst of a building market crisis. Should this particular event spark panic in the capital markets, a heavy risk aversion flow will send investors scrambling for a viable safe haven – and as conditions deteriorate that safety is increasingly dependent on liquidity. No asset is as liquid and fungible as Treasuries. That creates a serious predicament. Should the market take a medium-term view, they will recognize that there will be no immediate alternatives to US Treasuries and a one-step downgrade does not seriously erode its stability (it hasn’t for Japan). Then again, over the long-term, the loss of its iconic AAA-status will have serious consequences.

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