Thursday 17th October 2013
Good afternoon. Markets have reacted to the news that the US has averted hitting it’s debt ceiling, so today’s post is a quick analysis on the effect it has had on exchange rates.
Let’s start at the beginning; what is this debt ceiling that’s been in the news?
The US government is forbidden from borrowing more than $16.7 trillion by law, under legislation that dates its way back to World War I. The first debt ceiling was set at just $5bn, but as America has continued to spend more than it earns, it has repeatedly had to raise the debt ceiling nearly 100 times since then.
Defaulting on debt would be catastrophic, since trillions of dollars in capital flows are backed up by US bonds – a traditional safe haven. This could result in a credit crisis equal or worse to that seen during the financial crisis, so is obviously a nightmare scenario.
Before the agreement, how had it affected exchange rates?
Normal logic dictates that problems for the US would have caused the US Dollar to weaken. However, due to the fact that it’s a safe haven currency, it actually had the opposite effect.
Due to the uncertainty it generated in global markets, it actually strengthened the Dollar as investors sought the safety of the Dollar, and this caused Pound/Dollar rates to drop, and also Pound/Euro rates as investors sold the Pound and bought the Dollar.
So what has been agreed?
The 2 week political crisis came to an end last night as Congress voted through an eleventh-hour deal to re-open the government and avert a devastating debt default. After 16 days of government shutdown and only 24 hours before the deadline to raise the debt ceiling, both the Senate and House of Representatives voted through a compromise bill.
The shutdown is estimated to have taken a $24 billion (£15 billion) toll on the US economy while the Fitch rating agency to put America on “rating watch negative” ahead of a possible downgrade.
And what has the effect been on exchange rates now the US won’t default?
Once the agreement had been announced, those that had put funds into the US Dollar pulled back out into other currencies. This has caused the Pound/Euro rate and Pound/Dollar rate to rise, as you can see from the charts below.
I hope this has been useful in explaining how these recent events have affected exchange rates.
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