As anyone who has been following the VIX, US CDS (which is quite interesting as the US catastrophe trade appears to have become selling CDS to fund gold purchases in euros: more on that eventually), or stock markets in general has grown to appreciate all too well, no matter the amount of perceived risks, the market continues to shrug off any bad news: after all, the Bernanke put means that the greater the systemic shock, the higher the likelihood that the Fed will get involved yet again and push up all risk assets. However, the same can not be said about the dollar. The currency which in 2011 has traded like anything but the world's reserve currency is less than 1 point away from 2009 lows. But that could be just the beginning. Citi's head of FX has released a not warning about the potential coming avalanche to the greenback should debt ceiling negotiations hit a snag: "what we are looking at here is very much the tail risk event that the debt ceiling negotiations unexpectedly hit an impasse. The question is what the impact would be on USD." Englander's summary observations: 1) The USD will be in big trouble if investors get the sense that the debt ceiling negotiations have gone beyond the expected choreography into a zone where there is perceived risk to US credit; 2) More broadly, we think FX markets are increasing the attention they pay to fiscal sustainability relative to monetary policy; 3) The FX response may be non-linear so G10 countries may have a false sense of security in seeing little FX response to deterioration so far. Then again, perhaps a major step down in the dollar is precisely what the Fed wants...
Englander's summary view:
The 2011 budget impasse was resolved with little markets impact
If a breach of the US debt ceiling comes into question the impact will be larger
Since September 2009, a 100bps increase in CDS has been associated with 8% currency weakness …
… but there also is a level effect as poorer credits have faced larger FX pressures
The USD dodged the 2011 budget bullet last weekend and is now facing the debt ceiling cannonball.
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