What If the US Debt Bomb Explodes?

The clock is ticking as the US debt ceiling debate rages on, and the stakes have never been higher. These are the catastrophic effects that a default would have on the dollar, currency traders, and investors in general.

With a debt crisis brewing on both sides of the Atlantic, it is not surprising to see a bit of risk aversion this week. High-yielding currencies have weakened across the board while the US dollar, Swiss Franc, and Japanese yen inched higher.

President Obama has given Congress a July 22 deadline to reach a deal on raising the debt ceiling. Any later and there may not be enough time to write and pass legislation before money runs out on August 2.

Unfortunately, the mere prospect of a debt crisis in the US has already scared some investors away from buying dollars. The latest Treasury international capital (TIC) flow report showed foreign investors selling dollars for the first time in 11 months. Demand for greenbacks fell by $67.5 billion in May, which was the first negative print since June 2010 and the largest sale of US dollars since July 2009.

There was some demand for long-term US Treasuries, but short-term securities were sold for the seventh month in a row. The lack of demand for short-term assets reflects concern about the US government’s ability to repay short-term liabilities.

Given the little progress made on raising the debt ceiling between May and July, there is a reasonable chance investors continued to bail out of US dollars. There was also a large negative change in the foreign liabilities of US customers managed by US banks or broker dealers that contributed to overall decline in Treasury international capital flows. Long-term TIC flows rose by $23.6 billion in May, but this was the smallest increase since January 2010.

Although China has pressured the US to protect the interest of its investors, they remained net buyers of US dollars. Russia, on the other hand, continued to put their money where their mouth is. The nation has been talking about diversifying out of dollars and into euro for months, and even though they have sold dollars gradually in recent months, they stepped up the pace in May.

Luxembourg was also a big seller, and given the country’s tax-haven status, the outflow should be a reflection of European investors moving money out of US dollars and into Swiss francs—a behavior that has probably continued in June and July.

NEXT: What If Debt Ceiling Isn't Raised?

US Debt Showdown

The debt showdown in Washington will be the market’s biggest focus this week. However, as we get closer to the August 2 deadline to increase the debt ceiling, ratings agencies and investors alike are starting to realize how bad things can get if the ceiling is not increased.

Two of the top rating agencies in the world have already warned that they will strip the US of its prized AAA rating if the debt ceiling is not increased over the next two weeks. China, the US’ largest creditor, called on the US to protect the interest of its investors because they also realize that a ratings downgrade can have a cataclysmic effect on the US dollar, and in turn, the value of their portfolio.

With a little more than two weeks to go before the US Treasury runs out of money and effectively defaults on their debt, the clock is ticking.

Unfortunately, Republicans and Democrats can’t seem to reach an agreement on anything outside of the fact that they are running out of time. The US government must raise the debt ceiling by August 2 or face dire consequences.

Let me tell you how bad things can get if the debt ceiling is not increased: The US has never had anything but a AAA rating, and this is the single biggest reason why the US dollar is seen as a safe-haven currency.

Investors know that no matter how uncertain the global economy may be, US Treasuries are the safest in the world because the US government has never missed a debt payment. It is this flight to quality that has kept US interest rates low and the economy supported.

If the US were to lose its AAA rating, foreign investors would start to question the security of US Treasuries and some investors, like China, would start to reduce their holdings, which would in turn drive US yields higher.

With such an anemic recovery, the US government and the American people will not be able to handle higher borrowing costs. Stocks would also fall significantly, as investors shun US assets and worry that higher yields could eat into profitability.

This is a slippery-slope scenario that the US government cannot risk falling into, and thankfully, the one thing Republicans and Democrats do agree on is that the consequences would be very severe. In fact, Standard & Poor’s put the chance of a downgrade at 50%, which means they believe there is a one-in-two chance that the US debt ceiling will not be increased in time.

Monetary policy alone gives investors very little reason to own dollars, and a downgrade would take away the only reason, which is the safe-haven status.

The Republicans have until Saturday to tell President Obama whether any of the three options he proposed to trim the budget would win GOP support. Their choices are:

• $4 trillion deficit-reduction deal that includes raising taxes and cutting entitlement programs
• $2 trillion deficit-reduction package
• Much smaller package that would raise the debt ceiling but include no tax increases or cuts to entitlement programs

A backup plan proposed by the Republican Senator from Kentucky could also be a viable solution. His plan includes raising the debt limit in three stages, totaling $2.5 trillion by next summer.

This plan is quickly becoming the most likely option even though it doesn’t directly address the issue. It only buys the US government time until the economy recovers and tax receipts are significant enough to cover part of the deficit.

It doesn’t take much to avoid Armageddon. Everyone just has to put their political agendas aside and raise the debt ceiling, which we think is likely to happen.

By Kathy Lien of KathyLien.com