Stop gap debt ceiling solution would be a drag for U.S. dollar

It appears Washington will probably just manage to thrash out a deal to lift the U.S. debt ceiling at the last minute. But it will likely be a stop gap solution meaning fears over a U.S. debt default will be visited more regularly with long-term negative implications for the U.S. dollar (NYBOT:DXZ13).

Any deal that stops the U.S. from defaulting on its debts this week is likely to spur a relief rally for USD that would probably last into Friday – with plenty of short-covering.

But such are the political divisions in Washington is that the best they may be able to manage is to lift the debt ceiling for a few months to buy more time to squabble. And there's a risk that ever more regular debt negotiations will become a part of the U.S. political landscape as ideological divisions run so deep. A case of moving from one short-term sticking plaster solution to another.

That will massively complicate the U.S. Federal Reserve's monetary policy operations. Anticipating the damage constant debt ceiling negotiations will do to the economy, the Fed is likely to delay tapering their quantitative easing program well into next year. The U.S. economy still appears fragile and not strong enough to deal with fiscal shocks and constant political uncertainty.

EUR/USD waiting for news catalyst from Washington

Doomsday delayed

Looking toward Thursday there is still a possibility that there won't be an agreement in Washington. That may not necessary lead to a savage sell-off of the USD, at least not straight away, though weakness would be very likely.

It is possible that the U.S. Treasury could push the default date back a bit — probably by shutting more parts of the government to divert cash to pay Treasury coupons. Nonetheless, if Thursday comes and goes with no deal, it will put currency and asset markets on tenterhooks.

At that point the Fed and other leading central banks will be dusting off contingency plans on how to cope with a historic default of the world's largest economy, the holder of the world's reserve currency with the largest most liquid financial markets. Hopefully, U.S. politician won't test those plans — much more is at stake than their cherished ideological positions.

About the Author
Justin Pugsley

Justin Pugsley is the forex and gold markets analyst for New Zealand-based trading platform provider MahiFX. He is a keen student of markets, economics and history. Prior to working with MahiFX, Justin worked for a number of leading media organisations such as Thomson-Reuters and Dow Jones/Wall Street Journal.

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