Currency crisis ahead? Part 2: Credit limit reached

October 29th, 2009

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Since we wrote the last article, the first symptoms of a US dollar short squeeze are appearing- rising USD and falling stock prices. From Market Club’s trend analysis of the US Dollar Index, you can see that it has moved from a strong down-trend to a weak down-trend. Should the USD appreciate further, it is a good opportunity to sell it in this temporary surge of strength because it is a structurally weak currency in the long run.

However, what can upset this temporary strength in the USD is a currency crisis (or semi-crisis). As we sniff around for information and insights, we can’t help but smell some whiffs of a brewing USD currency crises in this coming November. But this is a tough call for us because it is based on a very strong gut feel that there’s something fishy going on that only select few insider knows. Not only that, such a crisis will be at odds with a short squeeze of the USD. Thus, it is possible that we may witness a big move in the global financial markets in November (i.e. a surge in volatility).

So, what may trigger a possible currency crisis next month?

For this, take a read at this recent news report:

Roughly $211 billion separates what the country [United States] owes and its self-imposed credit limit.

And by Friday, after another week of massive debt sales by the Treasury Department, that gap will likely have narrowed considerably.

It is now expected that the $12.104 trillion debt ceiling could be breached by the end of November.

You see, the US government has its own credit limit (albeit self-imposed)just in the same way you have a limit on your credit card. If a person relies on his credit card debt for his daily spending and hits the credit limit, he will in default unless that limit is increased.

Therefore, lawmakers will have to vote to increase Uncle Sam’s credit limit, as they had always done more than 90 times since 1940. If not, the US government will have to shut down (the last shut-down was in 1995). But a shut-down is hardly a show-stopper. What will stop the show is that this will imply a default in the US government debt, which means the value of US Treasury bonds will be marked down. That will crash the value of foreign nations’ dollar reserves (watch out, China), which will have major international repercussions. Not only that- since many banks’ toxic assets are replaced with ‘safe’ Treasury bonds, this will result in their assets turning toxic again.

It is assumed that Uncle Sam’s credit limit will be increased, since the alternative will be unthinkable and that there’s not one instance in history where it did not happen.

But there are a few hitches. Firstly, lawmakers usually vote on an increase before the credit limit is breached. Right now, they are busy with health reform and intend to talk about the credit limit after the former is wrapped up. But since the health reform is a highly divisive issue, it may take longer than expected. Furthermore, some law-makers may even threaten to veto any increase in credit limit as a bargaining chip in the health reform debate. Also, given the out of control debt position, some law-makers may demand more fiscal responsibility from the government.

So, it is very likely that the vote may come after the credit limit is breached. That means that the Treasury will be hard pressed to use every trick (including the dodgy ones) to get things going. Since the financial system is still under the Treasury’s life support, what will happen when credit is cut off while lawmakers wrangle against each other?