Sunday, August 7, 2011

The US Dollar and the S&P Downgrade

The new normal references a general shift in accepted expectations for an economy. We can also apply this to currencies as well. And, we are certainly looking at a new normal when it comes to the expectations and outlook for the US dollar.
Through the past week, the USD was struggling to gain traction despite wave of risk aversion that sent the benchmark S&P 500 falling into its worst dive since the recession at the end of 2008. This speaks volumes to the currency’s loss of status as the Forex market’s undisputed safe haven and its increasing dependence on its role as a last resort liquidity provider. This will complicate the picture for next week.
The downgrade of the world’s largest economy is not that big of a surprise. Though the Moody’s and Fitch reaffirmed the United States top credit rating this past Tuesday after the government rushed through a last minute debt reduction and deficit ceiling extension program.  We still saw Standard & Poor’s hanging back. This unwillingness to provide relief hung heavy over the market especially considering the group put the country on credit watch with negative implications (suggestion a 50/50 chance of a downgrade with 90 days) back on July 14th.
Still, the implications this move will have are vast. In virtually all pricing models for derivative assets (and even many spot markets), the US Treasury rate is used as the ‘risk free’ rate. This is an academic norm that carries very real world consequences. This change means that pricing is now up for debate. The US government debt is the world’s primary reserve asset. In other words, it creates the bulk of holdings for most central banks, sovereign wealth funds, private funds, banks, corporations and wealthy individuals’ portfolios. Because of this move by the S&P, there could be a serious effort to lighten the load of Treasuries moving forward.
There is the possibility of forced liquidation. Many of the largest holders of Treasuries have mandates that state that they cannot hold anything with less than an equivalent AAA rating. While many managers were scrambling to find waivers to circumvent this consideration, there will inevitably be a contingent that cannot avoid this and will have to sell US Treasuries off. More serious of a scenario is if the market is panicked into believing there will be a mass unwinding of Treasury exposure that might occur next week.
Over the long term, a gradual shift away from the Greenback and Treasuries is certain as this has been an objective and effort for much of the world over the past decade. This move will accelerate the process. In the medium term, the market faces the reality that there are no equivalents to US Treasuries. They are still the most liquid market. Further, one step off of an AAA rating is still exceptional. Even further, they will be faced by an immediate paradox as risk aversion is already in full swing and will likely worsen.
The demand for safety leverages the need for safety and severely limits the options for what can offer shelter. 
Posted by David Frank - Chief Analyst, AvaFX