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The political impasse in Washington and wrangles over the US debt ceiling, which is leading to a gradual shut down of the US government, is yet to seriously rattle market sentiment, but the longer it carries on the greater the risk of extreme market volatility.

Already, there will be no Non Farm Payrolls number  on Friday  leaving a void in traders’ calendars. So far the markets are focusing on the fact that forced government spending cuts will damage economic growth leading to the Federal Reserve kicking its quantitative easing tapering plans further into the future.

By  Justin Pugsley, Markets Analyst MahiFX.  Follow MahiFX on  twitter.

That’s a bearish scenario for USD and that is how the markets are playing it out – at least for the time being.

But the situation could easily get worse as the different political sides effectively play a game of chicken with neither side willing to yield. The resulting car crash would be a default on interest payments by the US government, which could happen sometime from  October 17  onwards. For many in the forex markets this is still seen as a highly unlikely event – but given the political divisions it can’t be entirely ruled out and the markets appear to be complacent about this.

The big question for forex traders is what happens to the USD in the event of a US default?

JPY could be a short-term haven of choice in the event of a US default

USD JPY US government shutdown debt ceiling default October 2013

Thinking the unthinkable – US debt default

Times of extreme panic and uncertainty usually lead to a flight to the USD. A default by the US would certainly call into question that safety status. It would also trigger a stock market crash and a savage sell-off in US Treasuries with foreign holders desperate to repatriate their funds to safer havens – if indeed any could be found. Even gold can’t all together be trusted as a store of safety under such conditions as it might get hit by margin selling.

JPY could for the short-term become the next safety haven currency of choice, partly accentuated by nervous Japanese financial institutions repatriating their funds back home and it is also a liquid currency backed by a single large economy, unlike the EUR. But given a US government default has not happened before in modern times it is difficult to judge how the forex markets would react.

In the absence of a properly functioning government the Federal Reserve and the regulators are likely to step in to try and manage the carnage in the markets and protect the economy. They could take one of several actions:

  1. The Federal Reserve could massively increase its quantitative easing programme to stabilise asset markets with no guarantee that it would work – this is likely to be bearish for USD.
  2. The authorities could shut down trading exchanges to curb selling pressure and if there was a run on the USD they could even impose temporary capital controls. Less bearish for USD.
  3.  It’s possible a temporary legal loophole could be found to somehow pay the interest on US government bonds pending an approval on the debt ceiling. This could trigger a relief rally for USD.
  4. In event of a default the government is likely to make stern promises that interest obligations will be honoured in full with interest paid on the interest in a bid to calm investors’ nerves. It depends if investors are too busy panicking to listen.

Agreement still most likely outcome followed by USD rally

Being forced into taking such drastic actions would be deeply damaging for trader and investor perceptions towards the US. It is also still more likely that an agreement will be hammered out at the last minute, but it may well only be very short-term and could make these fraught political negotiations a more regular feature. This would be damaging for the global economy and also for USD as it would imply that quantitative easing will simply carry on at the current pace for a lot longer.

The closer the US gets to defaulting on its debt obligations, the more volatility is likely to spike up and the more the market will be driven by news announcements from Washington.

However, once a deal is thrashed out, a sharp relief rally on USD is likely to ensue, in part driven by heavy short covering.