HAMISH MCRAE: Dollar dilemma after debt deal

There may be an agreement on the US debt limit. What then? Negotiations continued yesterday, but it appears that the government and Congress are still moving towards an agreement to raise the ceiling on the amount the federal government can borrow.

If they can get over the wire, there will be a sigh of relief. That optimism was also felt on this side of the Atlantic. The FTSE 100 index recorded a significant increase on Thursday and Friday and the German Dax index reached an all-time high.

Anyone who follows American politics knows that this is not about economics or finance, but about Congress reminding the President who is ultimately in charge—the old adage that “the President proposes and Congress decides.” These struggles have gone to extremes many times, with the government scrambling as it tries to pay its bills.

I remember going through the Tampa airport ten years ago and realizing that the government employees on duty had not been paid in over a month. We thanked them for their dedication, aware of the contrast to how UK public sector workers would have reacted under similar circumstances.

But a deal, welcome as it may be, will not solve the US government’s fiscal woes, and that is where the markets’ focus will now shift. The Treasury has reduced its cash balances since January and will need to rebuild them.

So it will issue a lot of debt in the form of treasury bills and notes. That will suck money out of the banking system and increase short-term borrowing costs for everyone.

The economic effect of this will, according to calculations by the Bank of America, be comparable to an interest rate rise of a quarter point. Of course, the people on the Federal Reserve board are adults, and if fixing the debt ceiling problem causes an unwanted credit squeeze, they can make up for it.

The Fed can cut interest rates and/or hold back quantitative tightening. It can, as it were, print the money. But this does mean that US markets are likely to be bumpy in the coming months, and that will affect markets here.

There are at least three questions hanging over the markets.

The first is whether the recovery in big tech stock prices in America continues, because what happens there influences sentiment here.

Take the biggest of them all: Apple. It tipped just over a $3 trillion valuation in intraday trading on January 3, 2022. It then briefly fell below $2 trillion in January this year, a massive destruction of wealth. Now the value is back to about $2.8 trillion. Millions of investors, including thousands in the UK, will be greatly relieved.

The second is the Fed’s response to lifting the debt ceiling – assuming, fingers crossed, we get confirmation of that in the next few days.

Central banks around the world, especially the Fed, are still in the position that after making one big mistake, they make the opposite. They failed to respond to the rise in inflation in time, with Fed Chairman Jerome Powell famously describing inflation as “transient” in mid-2021 when it was quite clearly not the case. Now they threaten to turn economic activity upside down by tightening policy too much.

The whole debt crisis now makes it much harder to estimate things. As I said, the Federal Reserve board is mature, but adults can make mistakes when they are afraid.

The third is what is happening to the dollar. Pretty much everyone, myself included, expected it to weaken over the summer. It did for a while, with both the pound and the euro well above last October’s lows.

But recently the dollar has recovered somewhat, causing the pound and the euro to fall. The question of great importance for the UK and Europe is whether we can increase our currency because most commodities are priced in dollars and we both need to reduce our import costs.

A simple example. Just before Russia invaded Ukraine, the price of Brent oil was around $85 a barrel. Now it is $75 a barrel. But last February the pound was about $1.35, but now it’s $1.25.

So in pounds sterling we pay almost as much for oil as we did before the war, despite the fall in the price of oil. Let’s breathe a sigh of relief if and when the US fixes this little problem. But let’s hope we end up with fairly solid US equity markets coupled with a slightly weaker dollar.