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Does the dollar care?

The US is on the cusp of a government shut-down and imminent breach of the debt ceiling, yet the US dollar seems largely ambivalent. There are 3 reasons why the dollar appears not to care at this point in time, but also signs that this ambivalence is changing.

The first reason is that the dollar is more a global currency than a domestic one. Now you would not think this around the time of the monthly payrolls release or the Fed decisions, given the ensuing volatility. But it remains the global reserve currency, out-stripping turnover in the second biggest global currency (the euro) by more than a factor of 2. At times like these, this is more a curse than a blessing because the dollar does not react in the same way nearly any other currency would react given the same circumstances, leaving politicians with the perception that financial markets are largely ambivalent towards the turn of events.

Secondly, we’ve been here before and survived, which again creates an air of complacency. It has been 17 years since the last shut-down under the Clinton administration, during which the wheels kept turning on the US economy. For the most part, the same held true for the August 2011 debt-ceiling stand-off, but it did cause the US to lose its triple-A rated status and also saw a deal reached right at the last minute. But it was from this deal that the sequester was born: automatic budget cuts intended to be so stringent that politicians would be pushed into a longer-lasting solution. They were not.

Finally (and related to the first point), there is the risk angle. The prospect of the world’s biggest economy shutting down the government and the uncertainty of the outcome leads investors to shun riskier assets. Perversely, whilst this does lead to some benefit for the dollar, what’s noticeable is that since the Fed’s decision not to taper asset purchases, the yen, sterling, Swiss franc and euro have all performed fairly well.

This latter point suggests that investors are moving against the dollar. This is notable because UK data has been falling short of expectations recently, arguing for a weaker pound. Note that the weekly CFTC data (a narrow snapshot admittedly) showed net longs on sterling turning positive for the first time since February. There are growing noises in the euro area regarding the potential for further policy measures from the ECB. Japan is also on the cusp of more policy measures. Yet all have overcome these largely negative winds to outperform the dollar.

The suggestion is that the dollar’s resilience may be starting to wear thin. This is particularly significant if a deal is not reached and the debt-ceiling deadline looms large. In isolation, it’s reasonable to ask how the world’s biggest economy can find itself in this situation on a seemingly fairly regular basis. The outcomes (i.e. last minute deals) are never positive for the longer-term fiscal outlook (i.e. tackling rising healthcare and entitlement spending), so at some point it will start becoming negative for the dollar. Perhaps the sooner it does, the more likely it will be that politicians strive for a better and longer-lasting solution.

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