Currency markets shrug off U.S. downgrade

By Vikram Barhat | August 8, 2011 | Last updated on August 8, 2011
4 min read

The historic decision by Standard & Poor’s to downgrade the U.S. credit rating may have created scandalous headlines, but currency markets were quick to price it in—shockingly in favour of the greenback.

And that trend may continue, according to industry participants in the Canadian financial market. From a currency standpoint, the first-ever downgrade of the U.S. seems to have fuelled the growing threat to the status of the U.S. dollar as the world’s reserve currency.

“This is viewed as yet another threat to the status of the U.S. [dollar] as a reserve currency, [but] these concerns have been with us for a long time and yet, despite that, when things have gotten particularly difficult in the world, investors have gone back to the U.S. dollar,” says Peter Drake, vice-president, retirement and economic research, with Fidelity Investments Canada ULC. “Over time, it is possible that we’d see a different role for the U.S. dollar, but you have to be careful about forecasting a sudden demise.”

As for the implication of the U.S. downgrade for the Canadian dollar, there are a couple of things to consider.

First, as a leading commodity market player, Canada’s currency is at the mercy of that market. It’s little surprise that commodity values have been sliding in the last 24 hours. That said, Drake says the growth in big commodity consumers such as China continues unabated, despite policymakers’ best efforts to slow growth. He points to forecasts that suggest China will grow at 9% this year. “That’s very strong economic growth, and that means there is going to be demand for commodities.”

Moreover, historically, the loonie has had an on-again, off-again correlation with the greenback. “If you look back over two or three decades, there are times the Canadian dollar has behaved one way in relation to the U.S. dollar, and other times it’s behaved a different way,” says Drake. “There have been times when the world seemed to look on the loonie as a North American currency, lumped in with the U.S. dollar. So during periods when the U.S. dollar fell against other currencies, so did the Canadian dollar.”

That has changed since 2002, when the U.S. dollar began to fall against the euro. The loonie and the greenback become disentangled and started moving in the opposite direction.

The loonie today responds more to the price of oil than the U.S. dollar, says John Kurgan, a senior market strategist at MF Global. “There is a high correlation [between] the Canadian dollar and the price of oil; the Canadian dollar sells off of the price of crude oil, which is [correlated more] to the slow world-growth scenario than the downgrade of the U.S. debt.”

Drake says it ultimately comes down to the perception of the market. “I’d like to point out that even when the U.S. economic growth has been slow, there have been times when the Canadian dollar has been quite strong, when markets viewed commodities as a dominant driver.”

The market hates uncertainty and is currently reacting to the two sources: the economic uncertainty and the uncertainty as to whether the U.S. government will do enough to address its fiscal problems. The latter was highlighted explicitly in the Standard & Poor’s managing director John Chambers’ defence of the rating agency’s decision to downgrade the U.S. credit rating by a notch to AA+.

Chambers was widely reported as saying, “The political gridlock in Washington leads us to conclude that policymakers don’t have the ability to put the public finances of the U.S. on a sustainable footing.”

Kurgan is one of many Canadians currently watching out for the possible knock-on consequences of the U.S. downgrade, aware that Canada once was in the same spot that the U.S. is now.

“We were in the [same] situation back in 1992 [when] we were at AAA and got moved down to AA+,” he says.

It took Canada 10 years to make its way out of this and regain its AAA status. The U.S., however, is a different story. “We are AAA, [yet] the loonie was down against the U.S. dollar [this morning],” evidence he says that, in times of uncertainty, investors still regard the greenback as the safe haven and are confident that the U.S. government has the ability to continue to pay its debt.

In other words, as far as investors are concerned, the AA+ is the new AAA. “While it’s a historical moment in terms of [S&P] downgrading it, [initial global reaction suggests that] countries will continue to buy U.S. debt and [are] showing a great deal of confidence in the U.S. market,” says Kurgan.

The market reaction, he asserts, has been the complete opposite of the move to downgrade the U.S. rating. “That’s the nature of the market; I don’t want to downplay the rating agencies too much, but markets are telling a different thing. They are [still] buying U.S. treasuries; there’s still strong support for the U.S.”

Rating downgrade, Kurgan says, is really a warning signal by the rating agencies that they don’t like the way things are going in the U.S. “[The U.S. dollar] is still going to be the reserve currency of the world; the rating agency [decision] makes headlines, but I’m not sure how it’s going to affect traders on a day-to-day basis,” he added.

Vikram Barhat