13 November 2013
“The recent budget stand-off has shifted the way the world views the US. Having kicked the can down the road, they now have until 15 January to finalise a budget agreement, failing which the debt ceiling will be reached by 7 February, bringing the world back to the edge of a fiscal cliff. While we don’t believe the US will default on its debt, in our view the perceived blundering by the Democrats and the Republicans has tainted ‘brand USA’. From around the globe, a number of red lights are flashing, which has implications for the standing of the US as the global reserve currency of choice," say Galloway.
He says uncertainty about a potential replay of the US government shutdown and debt ceiling drama early next year will “almost certainly unnerve markets again. While a multi-year budget agreement is what is needed, it may be too much to hope for."
The direct cost of the government shutdown is estimated at 0.6% of fourth quarter US GDP growth. “Despite all the talk of a potential American default, neither equity markets nor the US treasury market priced in this eventuality ahead of the October 17 deadline. At some level, the markets realised that the politicians would not allow the US to default on its debt as the implications would be catastrophic. A default would almost certainly have plunged the world back into a recession, potentially far worse than the 2008 recession caused by the collapse of Lehmans."
Galloway says a collapse in the US dollar and a surge in treasury yields would potentially destabilise the global financial system. Since all markets price off the US yield curve, interest rates around the globe could rise, choking off the current weak economic recovery. Collateral markets could go into a tail-spin as US treasuries would no longer be considered as adequate collateral against loans. Companies would have to find other instruments to use as collateral or liquidate assets into cash. This could have huge consequences, not only for credit markets, but also derivative markets. The yen, euro and pound would appreciate strongly on safe-haven demand, effectively eroding their export competitiveness. With the risk of deflation extremely elevated, the world could find itself in a 1930s-style depression.
Galloway says China downgraded the credit rating of the US following the 17 October agreement, citing uncertainty as the primary reason. “For some time now, China has been aggressively accumulating gold reserves in an attempt to break the link, or at least reduce its dependence, on the dollar. We expect they will be reluctant buyers of US treasuries going forward and will continue to diversify their reserves away from the dollar. London and Hong Kong have also agreed to begin trading directly in Chinese renminbi, eliminating the costs and uncertainties of first converting pounds and renminbi into dollars before settling trades. In the midst of the uncertainty, there has been an increase in credit default swap rates on US treasuries – indicating they are perhaps no longer enjoying unquestioned status as a risk-free asset."
He says the US enjoys some dividends from being the world’s reserve currency. The US trades more cheaply by avoiding frictional trade costs, and is able to borrow more cheaply thanks to a continued demand for its debt by the world’s central banks, pension funds and money markets. If the US loses its status as the globe’s preferred reserve currency, it may see escalating costs on a number of fronts that could negatively impact its growth and fiscal position.
“While we believe China is still at least five years away from becoming a global reserve currency, it seems clear that the US government has done real damage to ‘brand USA’ by choosing political posturing over tackling the very real issues of an unsustainable budget deficit. What happens from here on out is key. But irrespective of what happens, creditor nations are no doubt reassessing their exposure to the US, in particular their holdings of US treasuries," Galloway concludes.