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How Sequestration Will Impact Currencies

Grant Taylor | Stone | Getty Images

If you're thinking happy days are here again, you can be forgiven.

Stocks are inching closer to their all-time high, serious mortgage delinquencies are falling, and the overall U.S. economy is showing slow but steady growth.

But wait - the folks in Washington are at it again.

Sequestration and drastic budget cuts that start next Friday are becoming an ever more likely possibility, with Congress showing few signs of any willingness to negotiate a deal. And the consequences for the economy could be pronounced.

The question for forex traders, though, is what sequestration would mean for currencies. It's a U.S. problem, which should be bad. But it could make investors risk-averse, which would probably send the dollar higher.

David Woo, head of global rates and currencies research, thinks sequestration ultimately would give the dollar a boost.

"I think February data, which will start streaming in in two weeks, will show a sharp slowdown in consumer spending as the lagged effect of the payroll tax increase takes hold," he told me. "This will reinforce worries about the sequester and help safe havens like the USD to outperform."

Woo sees little chance that Congress will negotiate an end to this latest round of brinksmanship. Republicans and Democrats view the political risks to their respective parties from no sequestration deal as roughly equal, he says, which gives both sides little incentive to negotiate. Also, he says, "the sequestration may be the last stand for the Republicans in their fight for deficit reduction."

The likely standoff, Woo says, should lift the dollar against the Canadian dollar since risk aversion wil be buoying the buck even as Canada faces other pressures. "Given the recent weakness in Canadian data, nascent signs of slowdown in the US will only compound expectations that the Bank of Canada will need to join the chorus among other central banks trying to weaken their currency," he says. Woo thinks the U.S. dollar-Canadian dollar pair could reach 1.04 in the next four to six weeks.

Simon Derrick, chief currency strategist at Bank of New York Mellon, has another take on the prospect of sequestration.

"My only thought so far is that events in Washington will only encourage the Chinese to pick up the pace of currency liberalization," he told me.

It wouldn't be the first time a U.S. political tussle led to Chinese calls for currency liberalization - which could have a major effect on the dollar long-term. After the U.S. narrowly averted fiscal disaster in the debt ceiling debacle of 2011, Yu Yongding, a former member of the monetary policy committee at China's central bank, wrote in the Financial Times that "the danger for China is that it does not learn the right lesson – namely, that now is the time to end its dependency on the US dollar."

The Chinese have been taking steps to expand yuan-based global trade ever since. Today British officials said they are hoping to set up a currency-swap line with China to help finance trade.

Stay tuned.

Tune In: CNBC's "Money in Motion Currency Trading" airs on Fridays at 5:30pm and repeats on Saturdays at 7pm.

Learn more: The essential vocabulary for currency trading is on Key Terms Dictionary. Top currency strategies are broken down for you in Currency Class.

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