According to Citi's chief currency strategist, Stephen Englander, a debt ceiling breach would have disastrous implications on the US Dollar.
A debt ceiling vote will occur in the House tonight at 7pm EST. The vote is seen as purely symbolic as it is intended to fail since every republican will vote no.
Stephen Englander admits that a breach of the credit ceiling is priced in for neither the fixed income nor the FX markets. He takes a preliminary look at the implications of what this would look like:
- Our expectation is that the FX reaction to a debt ceiling breach would be sharper and probably more permanent that the FI reaction, because unhedged foreign investors will see another layer of risk that can not be 'fixed' in the way that cash flows from Treasuries can. The FX market reaction may not be catastrophic, given the limit to the fixed income damage that is likely to be permitted to emerge, but it would legitimately tax foreign investor patience and lead to further USD dumping whenever the opportunity arises.
- Foreign investors will see 1) an additional unwanted tool of macro policy added to an already impressive array of non-orthodox policies; 2) another US policy debate that entirely centers on US domestic political convenience and ignores the interests of foreign investors; 3) confirmation that US policymakers favor policy options that will almost inevitably weaken the dollar, even while swearing up and down that they adhere to a strong dollar policy and are simply targeting domestic objectives. (You are about as likely to see a Higgs boson smiling out of your morning coffee as find an instance where the US policymakers of either party made a policy move intended to strengthen the dollar. See the recent essay by Buiter and Rabhari: The 'Strong Dollar' Policy of the US: Alice-in-Wonderland Semantics vs. Economic Reality on the strong dollar policy. )
Most importantly, 4) while a domestic bond investor can be made whole in a cash flow sense with virtual certainty, there is no way that unhedged foreign investors can be guaranteed that any FX market reaction will be unwound similarly. Domestic investors may have some reason to see themselves doing as doing a bungee jump, but foreign investors are not sure whether the tension limit is set for 200 feet above the ground or 15 feet below.
This would certainly continue to damage the confidence of the US Dollar on a global scale. The calls to discontinue having the US Dollar as the reserve world currency will increase tenfold. And this time the moaning and groaning will lead to action.