THREE DEBT CEILING SCENARIOS

There’s still confusion over the debt ceiling outcome and how it will impact markets.  In a recent note Standard Chartered detailed three different scenarios that could unfold over the coming weeks.  They see the USA essentially kicking the can on the deal and possibly resulting in some credit rating downgrades (via Standard Chartered):

“Scenario 1: The debt ceiling is increased and the White House/Congress succeed at the last minute in reaching a credible fiscal consolidation plan, and avoids a downgrade of the US credit rating.

FX market reaction – This would be broadly USD positive, particularly against G10 currencies. In this scenario, we still think that EM currencies would remain resilient and gradually resume their outperformance against the USD.

Scenario 2: The debt ceiling is increased, but the White House/Congress fail to agree a credible fiscal consolidation plan and only arrive at a short-term compromise. Given recent comments from rating agencies, this would likely result in a downgrade of the US credit rating by one or more rating agencies – though crucially the US would remain investment grade. Our central scenario is that S&P downgrades US debt, but Moody’s and Fitch hold off doing so, for now.

FX market reaction – The USD would initially benefit from investor risk aversion, particularly against high-yield/high-beta currencies, both in G10 and EM, though not against safe-haven currencies such as the Japanese yen (JPY) and Swiss franc (CHF), which would significantly outperform. Thereafter, as benchmarked investor investment committees and central banks responded to the downgrade of the US within the investment grade category, there would be broad-based USD selling across the board.

Scenario 3: The debt ceiling is not raised and no fiscal consolidation plan is reached. In this event, rating agencies have publicly considered the possibility of slashing the US credit rating to selective default – a cataclysmic event for global markets.

FX market reaction – We see the FX market reaction to such a catastrophe as being largely a function of a total collapse in risk appetite – similar to the Lehman Brothers collapse, only of a much greater magnitude. As such, this would be USD-positive de facto rather than de jure, with all risk assets getting crushed. At some stage, the USD would come under massive and sustained pressure as investment committees sought to reduce their exposure to US assets, but this would only come after an explosive USD rally.

Currently, scenario 2 – a debt deal and a compromise fiscal plan, which would not be enough to avoid a US credit rating downgrade within the investment-grade category, is looking increasingly likely. We see this initially as risk-negative – and thus initially USD-positive against high-beta/high-yield currencies in G10 and EM – before a more sustained wave of USD selling across the board as investment committees and central banks react by reducing USD exposure. The schedule for these two stages would depend on market expectations and positioning heading into such an event, which now appears mildly USD short, suggesting significant market complacency regarding the risk of a US credit-rating downgrade.

Under this scenario, the likes of the Japanese yen (JPY) and the Swiss franc (CHF) would outperform higher-yielding currencies such as the Australian (AUD), New Zealand (NZD), and Canadian (CAD) dollars and EM currencies. Thereafter, we see EM currencies rebounding, benefiting from much stronger fundamentals and broad-based USD selling.

In response, the central banks of EM countries, notably those in Asia ex-Japan (AXJ) and Latin America, may respond first with intervention and thereafter further macro-prudential measures or even some form of capital controls. However, in our view, such measures are only likely to slow the speed of appreciation of EM currencies rather than reverse the trend.”

My guess is still that they will come up with some sort of agreement over the weekend that calms markets and gets the credit rating agencies to back down.  The downside risks are just too enormous if they allow this issue to fester….

Source: Standard Chartered