After the break down of debt talks in the US over the weekend the markets now seem to be primed for a US default. With 8 days to go until the US runs out of money, it is no wonder than the markets are spooked this morning. Stocks are lower, gold is surging (currently above $1,617) and even US Treasuries have started to get sold off.

This is bad news for the US Treasury as it is scheduled to hold an auction of $27 billion of 3-month bills and $24 billion of 6-month bills at 1630BST today. It is scheduled to sell a further $119 billion this week.

But will there be many buyers when the impasse up on Capitol Hill could see the US enter a technical default in 8 days?

These auctions will be key litmus tests to see if investors will call Washington's bluff, expecting them to come up with a solution at the 11th hour and averting a default.

The market reaction today is as expected. Stocks are lower and gold is surging higher. Europe's debt crisis is very much on the back burner, although Italian bond yields have started to slowly creep higher again. It could be a volatile week, and since European debt is moving closely with risk appetite, we would expect the weaker credit markets in Europe to get sold off.

The reaction in Treasury markets has been fairly muted considering the severity of the crisis. The chart below shows the 10-year -2-year US Treasury yield. This curve is a used to determine the state of the economy. When it is rising it suggests a healthy economic state, when it starts to fall it suggests tighter monetary conditions as short-term yields rise more than long-term yields. This is a lead indicator and can predict losses in commodities and stocks markets, which react badly to tighter rates.

The Fed's QE2 programme has impacted the curve as it has bought longer term Treasuries to push down yields. However, the current crisis should cause a further inversion of the yield curve, which leaves risky assets particularly vulnerable.

US 2-10's (white line), Thomson Reuters/ Jefferies commodity index (yellow line) and SPX 500 (green line). As you see in the chart below, stocks and commodities tend to move with the yield curve.

What about the dollar?

Over the last decade the US has had to consistently raise its debt ceiling as public sector borrowing has increased. In the past it has slipped by relatively unnoticed by the media, however, over the last decade the dollar has been on a downward trajectory, with only a few brief respites. The chart below shows the dollar index (white line) and the US budget balance as a % of GDP (yellow line) as you can see they have a long-term close positive relationship and the dollar has fallen as the US deficit has slid into negative territory


As the US's debt has blown out, this has weighed on the dollar. We believe the current mess in Washington is also dollar negative, however, we would prefer to express this via the Swiss franc than the euro.

Although USDCHF is close to record lows, this is the ultimate risk trade this week and it could fall further if things escalate. However, if there is an 11th hour deal on Capitol Hill then we expect this pair to swiftly reverse, possibly rising back to the 0.8190 pivot first then towards 0.8250 and 0.8300.

USDCHF hourly chart with MACD and RSI indicators


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