If US goes over fiscal cliff, dollar may fly A possible belt-tightening to slash deficit could indicate fiscal discipline and enhance safe-haven appeal of the greenback

If US goes over fiscal cliff, dollar may fly

A possible belt-tightening to slash deficit could indicate fiscal discipline and enhance safe-haven appeal of the greenback

In times of trouble, investors tend to flee to the comfort of the US dollar – even when the trouble is emanating from the United States. If Congress fails to reach a deficit reduction deal by the end of the year, it will automatically trigger big spending cuts and tax increases in 2013. This so-called “fiscal cliff” would hit the still-recovering US economy hard. But rather than bring the dollar down with it, the automatic spending cuts could be viewed as a sign of fiscal discipline that would benefit the currency. Even if a protracted period of negotiations injects a heavy level of uncertainty into the markets, that could benefit safe-haven assets like US Treasuries, and therefore, the dollar. “We risk a recession in the first half of the next year and if that happens, the risk-off trade will firmly be in play, which should benefit the dollar in the same way it did during the last recession,” said Greg Anderson, G10 strategist at CitiFX, a division of Citigroup in New York. In a “risk-off” market environment, investors tend to drift towards investments perceived as safe havens. Congress is not expected to debate until after the US elections on November 6, but if the Senate and House of Representatives end up in stalemate, roughly $600 billion in spending cuts and tax increases will emerge early next year. If a budget agreement is reached, then the US economy should be on pace for stronger growth in 2013. Both the Congressional Budget Office and International Monetary Fund have said the $600 billion in austerity measures have the potential to cause another recession. US Federal Reserve chairman Ben Bernanke has also warned that the tax increases and spending cuts will cause a sharp contraction in economic growth. “It will be a net positive for the dollar as money flows into the greenback based on safe-haven flows more than anything else,” said George Davis, chief technical analyst at RBC Capital Markets in Toronto. Last year’s bitter partisan fight in Congress over raising the debt ceiling, the legal amount the US Treasury is allowed to borrow, caused the dollar to outperform the euro as investors sold stocks and other assets associated with risk and fled to government bonds. In July 2011, the euro lost 1% of its value, with a 0.4 percentage-point loss in the final week of the month before the cutoff date for raising the debt ceiling. The US ultimately paid a price for the political partisanship, losing its coveted top-tier triple-A rating from Standard & Poor’s. Still, the dollar gained about 0.9% in the week following that downgrade. Government debt prices also gained. To be sure, a US “fiscal cliff” could have such a dramatic effect on the economy and markets that the dollar could eventually weaken as capital flees to regions with more stable macro policy frameworks. If that happens, the Federal Reserve may be forced to undertake new stimulus measures, a negative for the dollar. Nevertheless, the dollar’s status as one of the safest and most liquid assets in the world should trump those concerns. The fact that there are few large, liquid economies that currently have stronger fundamentals than the United States would stave off some of that flight. Traditional safe-havens such as the Japanese yen or the Swiss franc could serve as alternatives to the dollar, but Japan is having similar issues with sluggish growth. At the peak of the US recession in 2008, the dollar appreciated 4.3% against the euro. Against a basket of major currencies .DXY, the dollar rose 5.8%. “Should we hit another recession, the dollar could rise by 10%, with a 5% gain in December before we hit the ‘fiscal cliff’ and another 5% gain in January,” Anderson said. “The shock effect helping the dollar will wear off after that.” The dollar’s performance against the single currency shared by 17 countries also hinges on the state of the euro zone’s three-year old debt crisis.