US debt talks enter the home straight

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It is the progressive intensification of the rhetoric over recent days that offers the biggest clue that the impasse over the debt limit and fiscal policy will likely be resolved quite soon. Notwithstanding reports that yesterday’s talks ended badly, the President’s suggestion that he may summon some Congressional leaders to the White House this weekend signifies that he wants this resolved quite quickly.

This urgency is both commendable and necessary, as conveyed by Moody’s last night when it delivered on its previous warning that it would place the US on review for possible downgrade if there was no deal in place on the debt limit by mid-July.

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S&P claimed at the end of last month that it would stamp a ‘D’ notice (default) on the US if it could not make payments because it had not raised the debt limit. And the Fed Chairman claimed that the US faced a “huge financial calamity” if the debt limit was not raised. For the record, the US has been rated Aaa for 93 years, and was last put on review in the mid 1990s.

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 shortly 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 would 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 are growing. Moody’s stressed yesterday that if it did downgrade the US 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.

Michael Derks, Chief Strategist

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