Because the prevailing consensus is that the actual probability of Treasury missing a coupon payment is extremely low, like last week we are still content to sell USD on rallies above 1.3500, 1.5900 and 0.9050 in EUR/USD, GBP/USD and USD/CHF respectively. The logic here is simple: if the said probability is low, then fading rallies in the USD above those levels now will leave room for speculators to profit by buying the USD back more significantly once the debt ceiling is raised. Using Chart 2. below as a ‘guide’, the subtle but established widening of US CDS spreads alongside a weaker DXY implies that there must be at least a modest USD effect to the upside if a voluntary default on coupon payments is avoided.
However, in terms of positioning size, we also stand ready to lighten the load incrementally and then eventually steer clear of trading anything by this time Wednesday if nothing has been done to avoid a missed coupon payment on October 31st. At this point, the potential spillover of a US default from money markets to FX is incalculable, as the USD would have the ability to both rise and fall over the coming 4-5 trading sessions. On the one hand, demand for cash USD holdings could rise sharply, especially if ‘risk assets’ fall. On the other hand, some USD exposure from the closing out of riskier positions may be immediately swapped, and financial institutions might also scramble to hold non-USD, high-quality collateral.
As a very brief aside, the markets appear to have lost track of the main issues in their debate over whether Janet Yellen is really an ‘arch dove’ or not. The debate today is not about ‘hawkishness’ or ‘dovishness’, but about how far central banks can and should go to boost short-term growth when other structural factors are at play. Does it really matter if you are a traditional ‘dove’ or ‘hawk’ if you are of the belief that monetary policy should be used to keep short-run unemployment as low as possible after a crisis, and at any cost? Yellen has already done enough to declare which camp she is in, in this regard, so the debate is over.
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