The dollar after S&P’s decision to downgrade

YESTERDAY’S news of the downgrading of the sovereign debt outlook of the United States rocked markets on both sides of the Atlantic. The debt ratings agency Standard and Poor’s cut the long term outlook for the US from stable to negative for first time since the Pearl Harbor attack 70 years ago. S&P pointed to America’s “very large budget deficits.”

Following the budgetary deadlock between Republicans and Democrats, as both sides seem to be unable to face up to the country’s woes, the agency said “the path to addressing these issues is not clear to us,” adding “we believe there is a material risk that US policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013. If an agreement is not reached, this would in our view render the US fiscal profile meaningfully weaker than that of peer AAA sovereigns.”

We have turned to a selection of experts to ask views on the future of the dollar and America’s ability to take strong action to rescue its economy.

My view on the dollar is a tad more bullish than it was prior to yesterday. I believe the S&P revision could well spur US politicians into action. That action is likely to consist of bringing QE to an end and potentially raising interest rates. Now, I don’t believe the Fed will raise rates this year. I think they’ll wait until early next year but the dollar is likely to begin to rise in anticipation of any rate hikes.

The US dollar has somewhat bizarrely enjoyed a brief respite on the back of the S&P warning yesterday, but I think that is more to do with the problems in Europe than any faith in the US authorities.

What this downgrade has done is generate debate among US politicians about the growing size of the US fiscal deficit. It has always seemed arrogant presumption on the part of the US that they think that normal fiscal rules need not apply to them and this warning has thrown a new dynamic into the market.

However a lot of this is a sideshow to the current loose US monetary policy which is expected to remain accommodative for the foreseeable future. The only factor that could see the current US dollar rebound continue is a further deterioration in the European sovereign debt situation, and a contagion situation in the event of a Greek default.

When you have a $14 trillion debt burden, rising liabilities and a small tax take as you do in the US then your currency has to stay low for a prolonged period.

Monday’s announcement from Standard and Poor’s was a warning shot to the US government that it needs to take its head out of the sand and deal with its deficit now.

No matter how the US decides to tackle the deficit – rising taxes or cutting spending – each scenario is dollar negative. The upcoming period of fiscal consolidation will weigh on growth expectations and will push rate hikes from the Federal Reserve further into the future. This will weigh on the dollar in the short-term. Even in the long-term we think the dollar is unlikely to rise in any substantial way until the US gets its fiscal house in order. A weak currency will help the US re-balance away from consumption towards an export-driven economy, which will help heal some of its fiscal wounds. So weak growth prospects, low yields, and an economic re-balancing programme are all reasons for a lower buck in our opinion.

Thus far this year, the main factor influencing a weakening of the US dollar has been differences in monetary policy between the United States and the ECB. The ECB’s rate hike, while the Fed remains on hold, has resulted in growing interest rate differentials, attracting traders to the euro. Despite the rise in the euro, BCA Research indicates that the 2-year swap spread of rates is above the level seen at end of 2009, when euro-dollar reached 1.50, possibly indicating further upside in the euro, and downside for the US dollar. However, the US dollar could bounce short-term if the ECB falls short of the market’s expectation of three hikes this year or if strong US growth results in an rate hike earlier than the current market expectation of early 2012.