Why Downgrade Could Help the Dollar

08/09/2011 9:00 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

The downgrade of US debt has caused rampant fears and carnage in the marketplace, but this is not a death blow for the dollar or US Treasuries and may actually prove positive for the longer term.

This is the worst-ever start to August for the US stock market, and Monday only added to the craziness. On Friday, of course, Standard & Poor's dropped a nuclear bomb when they stripped the US of its long-term AAA credit rating. This is the first time ever that US assets have been rated anything but AAA, and the selling has already begun in Asia and Europe.

Although equities are down across the globe and gold prices rose to a fresh record high above $1700 an ounce, we have not seen a significant reaction in the US dollar. The greenback fell to a record low against the Swiss franc and has lost value against the Japanese yen, but it has strengthened against the commodity currencies and remains steady against the euro and British pound.

For the time being, with European markets not fully open, risk aversion has overshadowed safe-haven flows. Whether this price action lasts remains to be seen, but we believe that once the US market opens, the volatility in the currency market will increase. The market is waiting to take its cue from the US, and another 500-point selloff in the Dow would drive the dollar to fresh lows in the near term.;

There are a lot of moving parts at this time, and the only thing that we can say with complete certainty is that there will be a lot of volatility. Some analysts have argued that the downgrade is not a big deal and was expected, but based upon the way Dow futures were trading and the way that Treasury prices were expected to move on Monday, the downgrade of US debt is a much bigger deal than the downgrade of Japanese, Canadian, or Australian debt.

Canada and Australia both hold AAA ratings, but when Canada was downgraded in 1995 and Australia in 1986, there was not much reaction in the stock market. Still, however, none of these countries are in the same league as the US in terms of size and scope, which is why it is improper to compare the US downgrade to the downgrade of any other country.

NEXT: The World Enters Damage-Control Mode

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Damage Control

The fear of significant carnage in the markets has put policymakers around the world in damage-control mode. In the past 48 hours alone, there has been a global attempt to downplay the significance of the downgrade. Almost immediately after the downgrade, the US government questioned the credibility of S&P's decision and the accuracy of their calculations. US bank regulators also said the downgrade will not affect the risk rating of banks.

Countries around the world have expressed a vote of confidence in US assets, including Russia, who has been a loud proponent of diversification in the past. Russia said the downgrade "Can be ignored for long-term strategy." 

Although China took this opportunity to chastise the US for living outside of its means, officials stopped short of saying that they would stop buying US Treasuries. The reason is because these central banks know that if they even hinted at the possibility of diversifying out of US dollars, it would only add additional pressure on the markets. In another words, any skepticism about the soundness of US assets is better left unsaid at this time, because it would only trigger more volatility.

The G7 also held an emergency conference call and announced that they stand ready to act in a coordinated manner, if necessary.

S&P confirmed the short-term rating of US debt, which means that money market funds will not need to sell US assets immediately. The damage control may have stemmed the slide in the US dollar, but it may not be enough for US equities or Treasuries, and that is where the real risk lies.

All government-guaranteed instruments were at risk of a downgrade on Monday. If we see a massive selloff in stocks and bonds, currencies will follow. The fact that the G7 did not take action immediately after their conference call indicates that they want to see how negatively the market reacts before deciding what type of action to take.  

If the markets continue to collapse, there are at least two possible options for the G7. The first would be coordinated intervention to support the dollar. We all know that central banks around the world are not pleased with the weakness of the US dollar, but they have not done much to stem the slide and their own currency's rise because they know that unilateral intervention rarely works.

The Japanese and the Swiss attempted to intervene in their currencies last week, and the result was only a short-lived selloff. However, if US bond prices gap lower and yields gap higher on Monday, the Federal Reserve could agree to coordinated intervention because they will be desperate to find buyers for US Treasuries and it won't take much to convince the Europeans to buy dollars and weaken their currency.

The second option is asset purchasing. The European Central Bank reinitiated their purchases of Irish and Portuguese bonds last week and this week expressed a willingness to buy Spanish and Italian bonds. It would not be a stretch for the Federal Reserve to resume asset purchases as well.Doing so would help to stabilize the bond and equity markets even if it means risking the criticism of QE3.  

In Long Run, Downgrade Could Be Good for Dollar

In the long run, however, the downgrade could be good for the dollar because it will force more fiscal consolidation. Also, once the knee jerk panic selling of dollars subsides, investors will realize that US Treasuries remain the world's benchmark. No other market can absorb as much liquidity as the US Treasury market, and for this reason, Treasuries could still be seen as a safe haven.

Unless central banks with currency pegs want to see a sharp appreciation in their currencies, they too will continue to buy dollars. China won't be abandoning US Treasuries anytime soon, even though this would be the perfect opportunity for them to convince their trade partners that bilateral swaps that exclude the US dollar is the way to go.

In the meantime, the Swiss franc and gold will perform the best, but the countries with a brighter outlook and strong fiscal finances should also see greater demand for their currencies.  

By Kathy Lien of KathyLien.com

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