Okay, I don’t want to be too depressing here, but the question “Why hasn’t the dollar collapsed?” is a valid one. There are a host of reasons why one would expect that it would have. Markets are often said to hate uncertainty and it is hard to think of a more uncertain situation than that faced by the US right now.
The government is partially closed, tomorrow is the nominal deadline for the debt ceiling to be raised, and still no agreement has been reached. The current impasse is bad enough in itself, but one side effect is to delay the prospect of the Federal Reserve reducing bond purchases, or “tapering” Quantitative Easing. If nothing else, the prospect of continuing to inflate the supply of Dollars should put downward pressure on their value.
“Ah…” some might say “… but it has dropped significantly in the past few weeks.” The US Dollar Index (a weighted average of the dollar’s value against other currencies) has indeed fallen recently, but not to levels that would reflect the doomsday scenario the currency apparently faces.
The chart above shows the last 5 years of values for the index. The drop from around 85 to current levels just above 80 is significant, but hardly Earth shattering. A simple mean calculation based on approximate 5 year highs and lows of 90 and 72 yields a value of 81, so it would seem that the current levels are about neutral. This doesn’t seem to make sense.
First, let me tell you what I don’t believe this signifies. There are some that maintain that this lack of panic in markets tells us that not raising the debt ceiling, and any subsequent default, would be no big deal. They couldn’t be more wrong.
US Government debt is the foundation of the global financial system. It is the“risk-free” asset by which all others are judged. In the event of a default, the risk-free status of that asset would be called into question. If you want to know what happens to a country’s banking system when the sovereign bonds of that country are questioned, take a look at Greece a few years ago. Of course, the situations are different, Greece’s problems were based on a perceived inability to pay, while those of the US would be based on a perceived unwillingness to pay, but for bond holders the reason for a default is irrelevant; the damage would have been done.
The domestic troubles wouldn’t end there. The Social Security fund is largely invested in government paper and a significant decline in values there may put future payments in doubt. That in turn would spook businesses and put more pressure on an already fragile jobs market. The shock-waves would continue to ripple outward.
To those who maintain that the Government could just prioritize payments and keep the bond markets happy, I would say this. Do you believe that, were you to refuse to pay your mortgage for six months, that that would have no bearing on your ability to get a car loan? When considering the risk associated with lending, all obligations are seen as the same and, as that risk increases, so does the risk premium, or interest, demanded. Higher rates mean lower bond values, and for the possible effects of that, I refer you to the paragraph above.
If anything, it is the very magnitude of the problems default would cause that has limited the reaction in the currency market. Those who control the world’s big money are all too aware of the consequences, so they do not believe for one minute that it will actually happen. They expect that the usual theatre of brinkmanship and a last minute deal will be played out again.
If this sounds familiar, it is because I have written it many times in reference to the US stock market. The lack of panic in the foreign exchange market is what leads me to believe that fears of Armageddon are overblown. Both my history in that market and 30 years of observing it lead me to conclude that it is usually a pretty good indicator.
There is another reason that the Dollar refuses to reflect the pessimists’ predictions of approaching doom…there isn’t anywhere to hide. As we saw in 2008/9, the effects of banking crises that may originate in the US are not contained there for long. To a large extent, as goes the US economy, so goes the world. There are few, if any, economies in the world that are robust enough to withstand major disruption at the moment. Despite being the potential cause of problems, the US still looks like the best of a bad bunch to many.
So, for now at least, the US dollar remains stronger than the circumstances would seem to merit. I don’t expect a huge reaction if no agreement is reached tomorrow, either. While October 17th is the nominal deadline, payments won’t be missed immediately if nothing is done.
From a positional point of view, I remain bullish on the dollar in the long term. Over the last few months I have made several such calls, including Dollar Yen (USD/JPY) breaking back through the psychological 100 barrier and significantly lower Euro against the Dollar (EUR/USD), and several based on it, such as buying worry induced dips in the stock market. We are rapidly approaching crunch time, yet still there is no sign of panic in the currency market, so, if anything, my conviction in that view has increased.