US Downgrade Good for Dollar? Don't Rule It Out

Thursday, 28 Jul 2011 | 2:36 AM ET

With the prospect of a downgrade of U.S. debt in the cards, analysts at Danske Bank in Copenhagen are telling investors to be careful about the assumptions they make in the event of something that would have been unthinkable just a few months ago.

President Barack Obama
Photo by: Pete Souza
President Barack Obama

“For an investor belonging to the post-Bretton Woods economy, where the dollar is the reserve currency underpinning the system, waking up to discover that U.S. debt may not be AAA after all is surely a market event,” said Kasper Kirkegaard, a senior analyst at Danske Bank in a research note.

In normal circumstances, a credit rating downgrade would probably lead to a lower currency, but Kirkegaard said the key to how the greenback trades is more a matter of investors' appetite for risk.

“The dollar’s status as world reserve currency complicates matters, however, and introduces channels that could even prove dollar positive,” he said.

“While this may sound counterintuitive, this is exactly what happened when the U.S. was put on negative outlook by Standard & Poor’s on 18 April 2011: initially the dollar weakened, but as risky assets were sold off, the dollar ended stronger on the day,” Kirkegaard said.

With its reserve status, the dollar does not react as other currencies would be expected to.

If risk appetite declines and investors fly toward safer assets, the dollar is likely to be seen as a good place to hide from the risk-off trade.

“The dollar market is the most liquid in the world, and U.S. [Treasurys] have (until now) been regarded as the best instrument to secure capital protection," Kirkegaard said.

"This tends to increase demand for dollar assets during periods of falling risk appetite.” “The net dollar effect of a credit downgrade will thus depend on the increase in the U.S. risk premium (dollar negative) compared with the dollar positive flows resulting from a drop in market risk appetite, ” the analyst said.

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