Another take on THE DOWNGRADE, this time from Citi’s FX Guru Steve Englander, who ponders what it might mean for the Greenback.
The accelerated timing is a surprise and comes at a point at which global market sentiment is extremely weak, so it seems more likely that the reaction in markets will be negative than positive. The confidence impact in a weak market may be larger than the substantive impact based on the surprise in credit markets..
We would emphasise that the USD reaction against most currencies will probably follow broader market reaction. In particular, as emphasised below, if equity and commodity markets keep sliding globally, the main reaction is likely to cut long positions in equities, EM and commodities. These are mainly funded by short USD, so whether or not the safe-haven status of the USD is impaired over the long term, a downward shock to markets is likely to be USD positive in the near term. This is hardly USD positive once things settle down, but before they settle down, the short term will likely dominate the long-term.
As we discuss below, there may be concern in FX markets that the EUR AAAs are not solid, given the political and economic issues facing the euro zone and how conditions have worsened since the agencies last commented on ratings. Official and private investors instinctively may want to sell USD and buy EUR, but the EUR sovereign issues do not look better because the US’ looks worse, and a global risk-off response would be EUR negative. The key immediate investor worry is that no set of European policymakers is willing to buy sufficient peripheral and quasi-peripheral bonds to narrow spreads, so there is little pushback against the panic on Spain and Italy.
The biggest upside for the EUR would come if the ECB bought Spanish and Italian bonds and that might be enough to generate a global response among risk-correlated currencies, if it was done in sufficient size to convince the investors that contagion was overdone.
For more ideas about possible market impacts of the downgrade, see here.