What the US debt ceiling crisis could mean for the US dollar?

How does the US Debt Ceiling Crisis affect the value of the US Dollar?

America’s dominance in the global economy is facing significant challenges due to self-inflicted policy wounds. A critical impasse surrounding the debt ceiling has brought the spotlight back to the dollar’s unparalleled position in international trade and finance. 

What is the Debt Ceiling? 

The debt ceiling is the maximum amount that the US government may borrow to support programs such as social security, Medicare, and the military. Despite receipts from taxes and other sources, the government constantly spends more than it receives, resulting in a deficit. This deficit contributes to the country’s total debt.  

To borrow money, the United States Treasury issues securities such as government bonds, which must be returned with interest. When the debt ceiling is reached, the Treasury is no longer able to issue new securities, thus shutting down a key source of federal revenue. The debt ceiling was established in 1917 and has been lifted over 70 times since then. 

The 2023 US Debt Ceiling Crisis: What You Need to Know 

The debt ceiling crisis of 2023 had the potential to cause significant economic damage, emphasizing the immediate necessity for Congress to reform the debt ceiling framework and prevent future instances of political brinkmanship. 

  • The US reached its debt ceiling on January 19, 2023, initiating the crisis. 
  • Treasury Secretary Janet Yellen implemented temporary extraordinary measures to maintain government operations until June 1, 2023. 
  • Congress engaged in discussions to address the debt ceiling issue. 
  • Republicans proposed spending cuts as a precondition for raising the ceiling, while Democrats called for a “clean bill.” 
  • Concerns grew as the impasse raised the risk of government default and a potential recession. 
  • Congress raised the debt ceiling on May 12, 2023, with bipartisan support. 
  • President Biden signed the bill into law the following day, preventing a default. 
  • However, the political disagreement over debt ceilings remains unresolved. 

Presently, Democrats and Republicans are engaging in negotiations to reach an agreement on raising the debt ceiling. However, it remains uncertain whether they will reach a consensus before the government exhausts its available funds. Failing to strike a deal could lead to a catastrophic US default on its debt, profoundly impacting the economy. 

What Happens When the US Hits Its Debt Ceiling? 

The Federal Reserve, lagging in its response to rising inflation, a series of bank failures, and a political impasse on government borrowing, is eroding the authority of the United States. Meanwhile, geopolitical tensions are intensifying as the US supports Ukraine in its conflict with Russia and competes with China, two rivals ready to capitalize on any missteps by Washington, such as a potential US debt default. 

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Warnings about the diminishing prestige of the United States are widespread. Beth Hammack, co-head of the global financing group at Goldman Sachs Group Inc., expressed concerns on May 9, stating, “Anything that takes away our status as the world’s reserve currency, as the safest and most liquid asset worldwide, is detrimental to the American people, the dollar, and the US government.” 

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How does the US debt ceiling crisis negatively affect the US dollar? 

The US debt ceiling crisis has various detrimental effects on the US dollar.  

  1. Firstly, it generates uncertainty regarding the ability of the US government to honor its debts, which may prompt investors to sell off US assets, including US Treasury bonds. Consequently, this selling pressure can cause a decline in the value of the dollar. 
  1. Secondly, the debt ceiling crisis can result in higher interest rates. When investors are unsure about a borrower’s capacity to repay debts, they demand a higher risk premium. Increased interest rates can diminish the attractiveness of the US dollar to investors, further contributing to its devaluation. 
  1. Thirdly, the debt ceiling crisis can instigate a recession. Deflation occurs when the dollar depreciates, increasing import costs. A recession may result if inflation levels are elevated. 

Here are some specific historical instances illustrating the negative impact of the US debt ceiling crisis on the US dollar: 

  • In 2011, the US debt ceiling crisis resulted in approximately a 5% decline in the value of the dollar. 
  • In 2013, the US debt ceiling crisis led to an increase in interest rates of around 0.25 percentage points. 
  • In 2015, the US debt ceiling crisis contributed to a 0.2% decline in economic growth. 

It is important to note that the extent of the negative effects of the US debt ceiling crisis on the US dollar relies on multiple factors, including the duration of the crisis and the level of uncertainty it generates. Nevertheless, this evidence suggests that the US debt ceiling crisis can exert a significant adverse influence on the US dollar. 

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How does the Debt Ceiling Crisis affect US economic supremacy? 

The US Dollar, which is extensively used in international trade and financial transactions, still constitutes just under 60% of central banks’ official currency reserves. However, this figure represents a 25-year low, indicating a decline in its dominance.  

  • Countries like China, India, and Russia are advocating for de-dollarization as a way to assert their own hegemony and protect themselves against US sanctions. 
  • The pillars supporting the US dollar are showing cracks, raising doubts about the US economy and financial system. 
  • There are concerns over the US debt limit and the possibility of default, with potential catastrophic consequences. 
  • Even without a default, the US reputation for honoring its debts could be damaged, leading to higher borrowing costs and difficult decisions on spending cuts. 
  • The Federal Reserve’s failure to address rising interest rates and recent ethical controversies have raised questions about its oversight capabilities. 
  • The UK’s exit from the European Union has also impacted its appeal as a place for foreign investors. 
  • The battle over the US debt limit could have implications for US security and global perceptions of the dollar, US leadership, and American institutions. 
  • China could seize the opportunity to expand its influence if the US falters, presenting itself as a reliable leader. 
  • The debt limit drama is affecting US international engagements and undermining efforts to counter Chinese influence in the Pacific. 
  • US policies, such as interest rate hikes, have affected both friends and foes, straining international relations. 

In summary, the dollar’s dominant position is not guaranteed, and a war or financial crisis could lead to the rise of another dominant currency if its economy surpasses that of the US. The future status of the dollar as the dominant reserve currency depends on US policies. 

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What is the impact of US debt ceiling crisis on various sectors? 

A US debt ceiling crisis could have a significant impact on a number of sectors, including: 

  1. Financial Markets: During debt ceiling crises, financial markets can become turbulent as investors fear defaults. This can lead to a drop in the value of stocks, bonds, and other assets. 
  1. The Economy: A debt ceiling crisis can have a detrimental impact on the economy as a whole. A recession might occur if firms and consumers become more cautious with their spending and investment following a default. Economic development might be stifled, resulting in employment losses. 
  1. Government Programs: In the case of a debt limit crisis, government programs such as Social Security, Medicare, and Medicaid may be curtailed. These cutbacks may have an impact on the quality and accessibility of these programs. 
  1. Individuals: Individuals might suffer major consequences from debt ceiling issues. Jobs may be lost, asset values may fall, and interest rates may rise. Individuals may have a more difficult time saving for retirement, purchasing a home, or starting a company. 
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Past instances of US debt ceiling crises have had adverse effects on various sectors, encompassing: 

  1. Financial markets: The S&P 500 index experienced a decline of over 10% within weeks during the debt limit crisis of 2011. 
  1. The Economy: The 2011 debt ceiling predicament also impacted the US economy, leading to slower growth and increased unemployment rates. 
  1. Government programs: The debt ceiling crisis in 2011 resulted in the reduction of government programs, including delayed Social Security payments and layoffs within the Department of Defense. 
  1. Individuals: The 2011 debt ceiling issue significantly affected individuals, leading to job losses and depletion of retirement savings. 

Considering the serious threat posed by the US debt ceiling crisis to both the economy and individuals, it is crucial to be aware of the risks and safeguard one’s finances. Here are some recommendations for protecting your finances: 

  1. Establish an emergency fund: Being prepared with an emergency fund helps in tackling unforeseen financial circumstances. 
  1. Diversify investments: Spreading out investments can mitigate risks and minimize losses during downturns. Here’s an ultimate guide to Investment Portfolio Diversification that can’t be missed! 
  1. Stay informed: Keeping up-to-date with the debt ceiling crisis and its developments enables better preparedness and decision-making. 
  1. Reduce your debt: Minimizing debt reduces vulnerability to sudden shocks during uncertain times. 

What is the best way for investors to prepare for a debt ceiling crisis? 

Here are some strategies for navigating the debt ceiling crisis in the stock market, as recommended by financial professionals: 

1. Consider investing in defense stocks 

Defense contractors could benefit from a deal to raise the debt limit, as the government may need to increase defense spending. One option is the iShares U.S. Aerospace & Defense ETF (ITA), which is the largest defense contractor exchange-traded fund. It provides targeted exposure to U.S. companies involved in manufacturing commercial and military aircraft, as well as other defense hardware. ITA includes stocks such as Raytheon Technologies (RTX) and Lockheed Martin (LMT). The fund has a relatively low annual expense ratio of 0.39% and has performed well, with a total return of 15.54% over the past 12 months compared to a 6.76% return for the S&P 500 Index over the same period. 

However, it’s worth noting that in the past month, the ITA fund experienced a decline of 4.62% while the S&P 500 gained 0.91%. This could be due to investor concerns about companies heavily reliant on U.S. government revenues. If you’re an optimistic investor willing to seize opportunities regardless of the stock market’s situation, defense stocks, such as those included in the ITA ETF, may be worth considering during the debt ceiling crisis. 

2. There is no better safe haven than Gold! 

According to Miser, precious metals like gold could benefit from a U.S. default, making them a potential safe haven investment during economic turmoil. Investors may turn to gold and other precious metals to safeguard their wealth if the government fails to raise the debt ceiling and defaults on its debt obligations. 

One popular option for investing in gold is the SPDR Gold Shares (GLD), which is the largest precious metals ETF with $60.7 billion in net assets. It has an annual expense ratio of 0.40% and does not offer any dividend yield since gold is not known for generating significant cash flows. Despite the lack of dividends, the fund has performed well compared to its peers. It ranks in the top 10% of its Morningstar commodities fund peer group over the past 15 years and the top 13% over the past 10 years. 

Read Top Gold Trading Tips and Strategies to increase your profits! 

3. Is it a good idea to bet on banks? 

Investors believe financial services stocks could benefit from a debt ceiling deal, as a rising debt limit could lead to increased government borrowing and higher profits for banks and financial institutions. As a result, they recommend avoiding regional banks and divesting from them. 

The Financial Select Sector SPDR Fund (XLF), with $28.8 billion in net assets, has faced challenges but has a one-year total return of -1.44%. Derek Miser, CEO at Miser Wealth Partners, advises steering clear of banks due to the risk of a default and the potential decline in the value of their U.S. Treasury bonds and government debt. However, U.S. Treasury securities, including Treasurys, remain relatively safe assets even in a potential default. 

For long-term Treasurys, the iShares 20+ Year Treasury Bond ETF (TLT) is recommended. It has $36 billion in assets, a low expense ratio of 0.15%, and a decent dividend yield of 2.70%. However, TLT has experienced a negative one-year return of -8.53% due to rising Federal Reserve interest rates. 

4. How to navigate foreign currency investments 

The US debt ceiling crisis has potential consequences for the global economy and investors can shift away from the US dollar, leading to a decline in its value and an increase in other currencies. If investing in foreign currencies during this crisis, consider the following: assess risks, diversify investments, and conduct thorough research. 

Which Major Forex Currencies Performed Well In 2022?

Here are some foreign currencies to consider. 

  • Euro: The euro is the second most traded currency globally and is seen as a safe haven amid concerns about the US dollar’s stability. 
  • Swiss franc: The Swiss franc is another safe haven currency known for its stability and low volatility. 
  • Japanese yen: Despite its relative weakness, the Japanese yen is considered a safe haven currency, making it a potential investment during economic uncertainty. 

Remember that foreign currency values can fluctuate significantly, and profitability is not guaranteed. Here is a complete guide on how to start trading forex for beginners

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