The dollar is strengthening its positions across the market today. The greenback has more than made up for yesterday's losses, which it incurred against the backdrop of slowing April inflation in the United States. Looking ahead, it should be noted that the strengthening of the American currency, in my opinion, is emotional and, therefore, temporary in nature. Verbal speculation around a possible default in the U.S. has sparked a surge in risk-off sentiment. The beneficiary of the situation is the safe haven dollar, which enjoys the status of a defensive instrument.
However, such news-driven events do not usually last, especially since the default scenario seems highly unlikely: all discussions on this subject are politically tinged. Therefore, it can be assumed that in the medium term, emotions about the "financial apocalypse" will subside, and classic fundamental factors will return to the forefront—most of which are not in favor of the American currency.
The dreaded "default"
Debates on the U.S. debt ceiling are, so to speak, a peculiar political tradition in the U.S., during which key political players (i.e., Republicans and Democrats) actively argue, bargaining for necessary concessions in exchange for support votes.
As is known, the decision to change the ceiling must be approved by Congress and then signed by the head of the White House. The U.S. reached another national debt threshold of $31.38 trillion on January 19. In April, the House of Representatives passed a bill to raise the ceiling in exchange for budget cuts (these cuts will hit, among other things, the low-income health insurance program). The Senate and Joe Biden unanimously stated that they would not approve this bill.
The problem is that the current political landscape in the United States has turned the routine revision of the ceiling into a subject of political bargaining. Republicans, who control the lower house of Congress, demand budget cuts. Democrats, who, in turn, control the Senate (and whose representative heads the White House), refuse to make concessions to their political opponents. As of "now," Republicans and Democrats have failed to agree on raising the limit. Therefore, as early as June, the U.S. may declare a default on its debts, which would be a disaster for America and trigger a financial crisis worldwide. Negotiations between the parties are underway, but so far, to no avail.
Former U.S. President Donald Trump added fuel to the fire by urging his fellow party members to allow default "if the Biden administration does not accept congressional budget proposals."
A Game of Nerves
All these dances with tambourines over the past few days have had a background impact on the currency market. But today, the dollar has sharply strengthened its position, despite the slowing of inflation in the U.S. and a decrease in hawkish sentiment regarding future actions of the Federal Reserve.
In my opinion, a peculiar trigger was the statement by U.S. Treasury Secretary Janet Yellen, who urged Congress to raise the national debt limit "in order to prevent an unprecedented default, which will cause a global economic downturn and risk undermining America's leadership in the global economy." In turn, U.S. President Joe Biden said yesterday that Congress' inaction could lead to a recession in the U.S. economy—he reminded that the Treasury will run out of money to pay government bills as early as June 1.
Such statements came amid reports that talks between Republicans and Democrats have stalled. We can say that today the market participants realized the seriousness of the current situation, after which the safe dollar began to gain momentum against the backdrop of increased risk-off sentiment.
According to experts, there are several ways that theoretically will allow the U.S. to avoid default, even if Congress does not allow the national debt to be increased. Among them are even quite extravagant scenarios—for example, the Treasury Department can mint a "collectible" platinum coin of any denomination (even one trillion dollars) and get cash in the Fed under the pledge of this coin (the only question is whether the Fed itself will dare to take such a gamble). But for the most part, market participants are waiting for the classic unraveling of the plot: the proverbial happy ending.
In general, the experience of previous similar crises suggests that a compromise will be found, but political wrangling will continue until the last moment. And the closer the hour X is, the more the markets will be nervous. For example, 12 years ago, the struggle between President Barack Obama and the Democratic Senate with Republicans in the House of Representatives lasted until the last moment. The risk of default was so real that traders were seized with panic, and the U.S. credit rating was downgraded. It is quite likely that the current situation will unfold according to a similar scenario. At least at the moment, that is exactly what is happening.
Against the backdrop of emerging panic sentiment, the dollar is in high demand and, obviously, will continue to be so until there is a de-escalation in the form of a compromise solution. All other fundamental factors have taken a back seat. The EUR/USD pair is plummeting, ignoring the slowdown in U.S. inflation and the rise in inflation expectations in the Eurozone.
Conclusions
Classic fundamental factors have faded into the background: the dollar is benefiting from the current situation, which is too emotional and politicized.
However, the danger of this situation lies in the fact that once a compromise between politicians is reached, interest in risk will sharply increase in the markets, while the greenback will come under pressure. It's impossible to predict when this will happen, so it's most prudent to adopt a wait-and-see position on the EUR/USD pair for the time being.