Overview

As America inches towards a deal raising the debt ceiling, one wonders about the impending reaction of the foreign exchange market.  While domestic bond holders would see selling opportunities in the likely event that the Treasury drops its yields, foreign holders of U.S. debt would only see the downside – a weaker dollar.  In a Financial Post article, Steven Englander, the global head of G10 FX strategy at Citigroup Capital Markets, notes that the raising of the debt ceiling “would legitimately tax foreign investor patience and lead to further USD dumping whenever the opportunity arises.” 

History

The debt ceiling was created in 1917, in the Second Liberty Bond Act, in order to allow the Treasury Department to issue bonds so the United States would be sufficiently funded in entering World War I.

At the time, the Liberty Bonds’ long-term maturities allowed the government to reduce interest rates for the future, creating a cycle of low-interest and giving the Treasury greater influence in managing federal debt.  It was increased each year of World War II in order to further accumulate war funds, but only by a fraction of the amounts it has been increased in recent years.  For a frame of reference, the debt limit was $300 Billion during World War II.  Now it’s $14.2 Trillion (According to the Congressional Research Service, the limit was increased by $984 billion in 2003 alone). 

Current Status

The United States’ current AAA credit rating may be compromised as a result of another ceiling raise, Moody’s Investor Services warned Thursday.  This scenario would be most likely should a deal not be reached by August 2^nd.   Additionally, a failure to increase the debt ceiling would result in a catastrophic default, and spiral the U.S. deep into another recession.  This too would hurt foreign investors with large dollar reserves.  In the view of many foreign nations, the U.S. continues a hypocritical monetary policy – publicly stating that it is making efforts to keep the dollar as strong as possible, but taking actions that devalue the dollar, such as raising the debt ceiling.  As long as outside sources see the U.S. as unstable, it may be better for foreign nations to invest in gold or CFDs than in the U.S. dollar.