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Forex: Bad dollar deal

The agreement made in Washington to avert the fiscal cliff and re-open the government is a bad one for the dollar for four main reasons.

Firstly and most obviously, the uncertainty has not been removed, just pushed a few months down the road, with the borrowing authority extended to early February and the budget lasting to mid-January. The honeymoon period will be short, if indeed there is one, before the negotiations and demands start again.

Secondly, no deal made under such pressure and so late in the day is going to do anything to tackle the bigger underlying issues that the US needs to face up to. But this should also not surprise, not least because for the past two years, the US has ducked or just failed to agree on the bigger issues, as was the case with the ‘Supercommittee’ that resulted from the last debt crisis and Budget Control Act of 2011. On current policies, the Congressional Budget Office (CBO) sees the deficit widening continually (as proportion of GDP) from 2016 onwards. In twenty years’ time, the proportion of retirees to the working aged population will be 40%. Never forget that currently only 63% of the working age population in the US is actually in work, a result of the declining participation rate (at levels last seen in the late ‘80s). If this doesn’t change, then back of envelope calculations suggest that from having nearly 3 participating (in work, or looking for work) people for every retiree, the US will have 1.6 by 2035. The maths is simple: workers will be taxed a lot more; the government needs to spend less (per worker); or, people will have to retire later. All routes have implications, which is why governments are grappling with them the world over.

Thirdly, it’s difficult to see the US escaping a downgrade, either from S&P or Moody’s or both. We’re 2 years on from S&P’s downgrade of August 2011. The political process remains more fractured, the time-frames of deals are getting shorter and the long-term budget numbers have worsened (2020 and beyond). Back in 2011, S&P stated that plans fell short of that required to stablise medium-term debt dynamics (which resulted in the loss of the AAA status). Since then, whilst near-term CBO projections have improved (better economy, impact of sequestration), from 2029 onwards they have deteriorated (as % of GDP). Furthermore, recall that S&P cited pessimism regarding the capacity of Congress and the Administration “to leverage their agreement into a broader plan that stabilizes the government’s debt dynamics anytime soon”. The numbers and the politics have undeniably worsened since then.

Finally, albeit still slow, we are likely to see an acceleration of portfolio debt dynamics away from dollars. Of course, this does not mean a rush for the exits. Rather, it means switching debt issuance into other currencies (as Sinopec did last week in China), together with the renewed reduction of dollar reserve holdings by central banks (the proportion of known reserves having stabilised in the past 4 years).

As we’ve said often, the dollar’s reserve status is both a blessing, but more a curse during these times. A weaker dollar may be what is required to jolt the respective parties into action.

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