US House Speaker Kevin McCarthy and Republican Representative Patrick McHenry speak to reporters after a White House meeting to discuss the debt ceiling

Two things are likely to happen to the dollar if the US defaults, or even if the US is just downgraded by one or more ratings agencies. The first is that there will probably be an immediate surge in the value of the greenback if the US defaults. The second is that this surge will probably be unwound quite quickly, eventually leaving the dollar much lower than where it started.

Why do we see this two-stage reaction? Mr. Steve Barrow, Head of Standard Bank G10 Strategy said the first surge in the US dollar is due to the fact that asset prices would crumble and investors would scramble to pay down the dollar loans that most have made through the FX market to fund their positions. This is the typical reaction whenever a crisis happens and it does not matter whether this crisis originates in the US or not. Central banks will spin into action to try to avoid any dollar shortage from developing through rapid deployment of liquidity swaps but it is unlikely that these will prevent an immediate dollar surge.

The second act, which is a longer-term and more aggressive fall in the dollar would reflect the fact that a default would clearly undermine the stature of the US and the dollar in the global economy. This part of the story would only play out if asset prices start to stabilise and rebound, either helped by central bank swaps or not. A debt downgrade, as opposed to a default, would not generate such volatility in the dollar, but it would still be significant and hence something that traders and investors need to prepare for.

Just how big could these reactions be? Mr. Steve Barrow said, much would depend on whether there is only a downgrade, or a default as well. We see only the former as being worthy of consideration. Another factor is market positioning ahead of any default/downgrade. Here it would seem that the market is positioned for dollar weakness, at least against the euro, and this could magnify any initial dollar surge.

Data provided by the Commodity Futures Trading Commission (CFTC) shows that speculators (non-commercial traders) are holding 187k of long-euro contracts and that’s pretty high in historical terms. If we look at forecasts by analysts, most have favoured a stronger euro against the dollar and we think it is a fair bet that longer-term investors have biased their own positioning in this direction too. Hence there does seem to be a risk here that if the debt ceiling debacle results in sharp weakness in asset prices and a scramble for dollars it could be quite intense given that the market seems to be quite short of the greenback.

However, there are other indicators suggesting that the situation might not be so skewed towards a sharp dollar rally with risk-reversals, for instance, still bid for euro puts (at least at the 3-month maturity). We also have to bear in mind that recent evidence suggests that the quick addition of dollar liquidity by the Fed can stop excessive dollar strength.

For instance, during the height of the US regional banking strains in mid/late March the central banks moved to shift weekly dollar auctions to a daily basis and the result was that the dollar did not rise at all. Just whether this could be repeated in the case of such a seismic event as a default is very questionable. But a mere [sic] debt downgrade might just result in limit  ed dollar upside initially, even if positioning in the dollar seems heavily skewed to the downside. Quite clearly, it is pretty foolish to put numbers on this but we will try.

“In the case of a US default, we could see euro/dollar initially test, and perhaps breach the parity level but the subsequent snapback would leave us looking for euro/dollar to end the year closer to 1.25 than the 1.15 region we see at the moment”, said Mr. Steve Barrow.