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As Congress Kicks Can, It Also Kicks Dollar

Tuesday, 26 Jul 2011 | 6:07 PM ET

U.S. politicians, in the process of kicking the proverbial debt can down the road, are also giving the dollar a good swift kick.

The dollar declined broadly against the world's major and minor currencies Tuesday as Congressional leaders continue to bicker about whose deficit reduction plan is betterand what kind of plan could ultimately gain approval in the the House and Senate. So far, an agreement is eluding them, and the pressure is building ahead of the Aug. 2 deadline to raise the $14.29 trillion U.S. debt ceiling.

"There's a fear that what was put forth by both parties yesterday was going to be insufficient to stave off a ratings downgrade," said Alan Ruskin, who heads G-10 currency strategy at Deutsche Bank.

Republicans and Democrats have their own plans to trim the deficit, and they continue to be at odds over a Republican plan to raise the debt ceiling in steps, which would require revisiting the issue next year. The Democrats dropped their demand for increased taxes, and neither party is offering anywhere near the $4 trillion in cuts Standard and Poor's has said would be necessary to maintain the AAA U.S. sovereign rating.

"I don't think anyone believes the U.S. is insolvent. The ratings is the wild card and how it affects the whole risk spectrum," said Win Thin, senior currency strategist at Brown Brothers Harriman.

On Tuesday, the dollar hit a record low against the Swiss franc, which has also gained on flight from the euro. The dollar index, representing a basket of currencies, was down about a percent in the past two sessions. The dollar was also trading lower against the euro, yen, Canadian dollar, Australian dollar, British pound, New Zealand dollar, Swedish krona and a whole group of emerging market currencies.

"EM is a sea of green right now," said Thin.

Analysts said the dollar weakness is more about concerns about the debt rating than worries Congress won't raise the debt ceiling in time to avoid default. "I think this extremely broad-based dollar weakness that you saw after Obama's speech (Monday night) is something to take note of," said Nomura currency strategist Jens Nordvig.

"It was such a broad-based movement against everything that I think it is a little bit disturbing," said Nordvig, who is global head of G-10 currency strategy.

Analysts also note the dollar is selling off, while bonds are being bought and yields are falling. The stock market, while lower on the day, has not been moving dramatically. The dollar decline also comes in a week where markets expect to see that the second quarter grew at a 2 percent rate or lower though Tuesday's consumer confidence number was stronger than expected.

Nordvig said the dollar could spiral lower, if the debt is downgraded and that triggers a bond market sell off. "If you have the bonds selling off at the same time, then there's really no reason to hold these assets," he said. However, some of the alternative markets where capital would flow are not that large.

"They cannot absorb a lot of flow. I think it's ironic central banks are buying yen as well, not because it is a safe story but because it looks like like a safe story," he said.

Nordvig said there is now more than a 50 percent chance a downgrade will happen. "We could get past this debt ceiling thing, but the package would not be big enough to get the rating agencies to calm down. Now that the rating agencies are in motion, it's kind of hard to stop them," he said.

"I think the world is really in search of the safest assets now. We've already seen that benefit the Canadian dollar and the Australian dollar," Nordvig said. "Sweden is a dramatic outperformer on a day when the S&P is down. That is rare. There's a lot of stuff in the price action for the last 24 hours that you have to take note of."

The Swedish krona was up 1.5 percent against the dollar. Sweden is a AAA rated sovereign.

Thin said he does not expect that much fallout if the credit rating is cut.

"If it's just a one-notch downgrade, I don't think it's going to go down that hard," said Ruskin. He said a small U.S. downgrade is not a global contagion event, but he also notes that some investors will still switch into other AAA sovereigns.

The currencies he thinks would benefit are the Australian dollar , Swiss franc , Scandinavian currencies, and also Brazil, Chile and Asian emerging market currencies.

Besides the Swiss franc, the dollar made new lows against the Singapore dollar. It set post-crisis lows against the Thai baht, South Korean won and Phillipine peso, triggering interventions by central banks in those countires overnight. The Chinese yuan was also at a record high against the dollar Tuesday.

Strategists do not think the dollar decline and debt downgrade would impact the dollar's role as reserve currency. "It's very hard to come up with a good alternative. I don't think there's any real substitute and I think what's going to happen is people are trying to get some safe assets on board to the extent they can but there's no replacement for the dollar. It's going to have a huge impact on the other currencies. It's going to be a huge flow for these smaller economies to absorb," Nordvig said.

Questions? Comments? Email us at marketinsider@cnbc.com

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