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What a Downgrade Would Mean for the Dollar

CNBC.com

Even a debt deal may not prevent a rating cut for U.S. debt. Here's what it would mean for the dollar, and what you can do.

United States debt has been AAA-grade stuff ever since credit ratings were invented, for Pete's sake. So it's jarring to realize that a downgrade is a real, and growing, possibility. But that's the reality we're living - and trading - in. So what would a rating cut mean for the dollar?

The short version: nothing good. But then the experts differ.

Alan Ruskin, head of G10 currency strategy at Deutsche Bank, has developed four scenarios for the eventual resolution of the mess in Washington:

- A deal that is sufficient to head off any rating cut

- A deal that avoids default, but still leads to one rating agency cutting one notch

- A deal that's so lacking, U.S. debt is downgraded several notches

- Default.

Ruskin pegs option 2 - a single-notch rating cut from one major rating agency - as the most likely scenario, and even that, he says, would hurt the dollar. It "may be the emerging consensus, but there is still some shock value in an actual downgrade, that could see dollar indices, like the DXY, lose another 2%," he wrote in a note to clients.

Worse, if the U.S. takes a bigger hit on ratings, as in option 3, Ruskin expects many more ripple effects, and "major risk-off" sentiment in the currency markets. In the short run, that could conceivably hurt investors with short U.S. dollar positions, but Ruskin cautions that "We believe this cannot be the foundation for USD gains on a multi-day basis."

Another way to evaluate the impact of a downgrade is to think about what it would do to trading patterns. The dollar has long traded as a major safe haven in the currency markets. But whether it would retain that status without a clear triple-A rating is unclear, says Jens Nordvig, head of G-10 foreign exchange strategy at Nomura Securities.

The data Nordvig has uncovered is not exactly reassuring. "Over the last week, there has generally been a shift with the dollar moving in the same direction as the S&P500 in four out of the last five trading days (a more "normal" ratio has 1:3)," he wrote in a note to clients. "A world where the dollar cannot garner support from risk aversion is by definition a world where the dollar has lost its safe-haven status. And based on recent trading sessions, it appears that we are heading towards this reality."

Nordvig has noticed another disturbing pattern with the dollar and Treasurys. Usually, the dollar rises when Treasury yields rise (and prices fall.) But lately, the reverse has been happening, as you can see

in this chart.

It's another indication that the dollar isn't being treated like a safe haven, Nordvig says - and it makes it riskier for foreign central banks to buy dollars, since they're no longer a hedge against falling Treasury prices.

If the dollar stops trading like a true safe haven, and U.S. interest rates are well below those of most AAA-rated currencies considered risk-on....yep, that's bad.

So how can you trade on a possible downgrade? Both Ruskin and Nordvig say safe triple-A rated countries' currencies - the Canadian dollar, the Australian dollar, the Swiss franc, and the Scandinavian currencies - should do well. Ruskin also says that Latin American and Asian currencies "will likely over time do OK, the former helped by commodities (helped by the multiple reflationary effects of a weak USD), the latter more by rates and a further breach in the USD-Asia currency axis in our view."

The bottom line: until Congress comes to its senses and the rating agencies respond, you're better off steering very clear of the greenback.

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

"Money in Motion Currency Trading" repeats on Saturdays at 7pm.

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