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S&P’s warning on US debt is different to Moody’s and reflects that this downgrade possibility is not a binary choice for it; in other words, keep the AAA rating if the debt limit is raised in time or lose it if not.   It goes beyond that because, if what emerges ahead of the deadline is a weak compromise that fails to tackle the longer-term issues of entitlement spending (which remains sacrosanct to many on Capitol Hill), then the US could still be downgraded.  

S&P estimates a 50% chance of a downgrade in the next three months “owing to the dynamics of the political debate on the debt ceiling”.   Indeed, there are also shades of this in Europe, given the inability of politicians on either side of the Atlantic to get on top of the situation.   Both the US and eurozone governments are posturing to short-term domestic electoral challenges and not appreciating the bigger picture (which is debt-sustainability over the coming decades).  Whilst it seems that EU leaders are planning to deal with Greece after the summer holidays, the US does not have that option (it also doesn’t get six weeks holiday a year), so this weekend’s meetings will be crucial for all asset markets.

Guest post by FXPro

Commentary

 

Dollar still resilient to debt warnings.   The dollar has still held up relatively well against the latest debt warning from S&P, although has largely retained the softer tone gained at the beginning of the Asia session. The biggest overnight mover has been the Aussie, with some talk emerging that the central bank could actually cut rates this year. This came from Westpac Bank and reflects the large shift in sentiment we have seen so far this year, with the market still pricing in the risk of higher rates at the start of the year.

New highs and momentum for gold. It’s been a near perfect storm for gold over the past twenty-four hours. In Europe, the notion of a debt-restructuring in Greece is gaining stronger political acceptance. In the US, the prospect of a downgrade has grown stronger as the latest round of debt ceiling negotiations has collapsed. Meanwhile, the Chairman of the US Fed has outlined the conditional possibility of further quantitative easing. It was only a matter of months ago when the Fed was more inclined at such key opportunities to outline the process for policy normalisation. The prospect of further quantitative easing, allied with governments failing to get to grips with their respective debt issues, has seen gold climb for eight consecutive sessions and today is threatening a break above the $1,500 an ounce level. The signs that this is not just a passing move are that the dollar has actually increased in value over this period, something that would normally pressure gold lower. Furthermore, we’ve seen holdings in ETF gold funds jump 1.2% this week, the largest weekly increase since early March. There’s been a similar shift in miners, with mid-week volumes the highest for over two months for some of the gold mining-based ETFs. Finally, the decline in global real interest rates has also proven supportive. All in all, the moves we’ve seen this week suggest that the fundamental underpinning of the current gold rally remains firm.

US debt talks enter the home straight.  It is the progressive intensification of the rhetoric over recent days which offers the biggest clue that the impasse over the debt limit and fiscal policy will likely be resolved quite soon.  Exactly what shape any final deal will take is still highly uncertain. The President is after a grand bargain worth $4trln, with substantive cuts to Medicare, Medicaid and social security in exchange for at least $1trln in revenue. Apparently, the two sides have agreed spending cuts worth $1.5trln, but the Republicans are demanding that it needs to be at least $2trln in order for them to agree to raise the debt ceiling. If there is continued gridlock at the planned weekend talks then there will come a point when the markets will start believing that US politicians could be short-sighted enough to let the US default. Should a deal be agreed, but one that merely lifts the debt ceiling by a small amount (thereby guaranteeing that the issue will remerge next year), then this would not be well-received by the dollar or treasuries. With less than three weeks until the debt limit deadline, the risks to the country’s credit rating is growing. Moody’s stressed yesterday that if it did downgrade the US then there was no guarantee that the Aaa rating would be regained any time soon. The spotlight for FX markets is now, quite rightly, focused squarely on Washington.