Debt ceiling crisis – is there any lesson for traders from the last one?

  

Mid-2011, the last time the US Congress was paralyzed by the reluctance of the Republican Party to cooperate with Democratic Party fiscal policy, leading to a fear, unrealized at the time, that the government would have to stop functioning because it could not borrow for day-to-day requirements and that the annual budget could not be finalized, is not really that long ago.

There have been one or two changes since then. For one thing, Barack Obama has been returned as US President for a second term. This is bad for those who seek a compromise, because he cannot run for a third term and therefore does not have re-election pressure on him to agree to half measures on his policies. There is also the perception, at least, that there is light at the end of the economic crisis tunnel. The Republican Party’s supporters will not thank them for placing that in jeopardy.

And there is some unfinished business since 2011. At the height of that debt ceiling battle in Congress, Standard and Poor's downgraded the credit rating of the United States. It was the first time in history that any rating agency had done that, and it has never been reversed. What happened in the markets is instructive. Fears for global instability drove money into US government bonds (even in a crisis, the US was still then regarded as the ultimate safe haven, which highlights the absolute irony of all this). Such a development, in turn, reduces bond yields (a proxy for interest rates) and leads to a reduction in US dollar strength.

But is it possible that, on this occasion, with the prospects in other global economies on the rise, a downgrade by other agencies would trigger a flight from US treasuries this time round, which would have exactly the opposite effect, a raising of bond yields and a consequent dollar rise? This would tie in nicely with the medium to long term expectation that, whatever about recent events, Quantitative Easing (QE) will be discontinued, leading to a dollar rise, and the only thing that is unknown right now is the timing for this.

The ending of QE (QE2 had started in 2010 and QE3 was yet to come) is another thing that was not in prospect in 2011.