NEW YORK – In times of trouble, investors tend to flee to the comfort of the U.S. dollar – even when the trouble is emanating from the United States.
If Congress fails to reach a deficit reduction deal by the end of the year, it will automatically trigger big spending cuts and tax increases in 2013. This so-called "fiscal cliff" would hit the still-recovering U.S. economy hard.
But rather than bring the dollar down with it, the automatic spending cuts could be viewed as a sign of fiscal discipline that would benefit the currency.
Even if a protracted period of negotiations injects a heavy level of uncertainty into the markets, that could benefit safe-haven assets like U.S. Treasuries, and therefore the dollar.
"We risk a recession in the first half of next year and if that happens the risk-off trade will firmly be in play, which should benefit the dollar in the same way it did during the last recession," said Greg Anderson, G10 strategist at CitiFX, a division of Citigroup in New York.
In a "risk-off" market environment investors tend to drift towards investments perceived as safe havens.
Congress is not expected to debate until after the U.S. elections on November 6, but if the Senate and House of Representatives end up in stalemate, roughly US$600 billion in spending cuts and tax increases will emerge early next year. If a budget agreement is reached, then the U.S. economy should be on pace for stronger growth in 2013.
Both the Congressional Budget Office and International Monetary Fund have said the $600 billion in austerity measures have the potential to cause another recession.
U.S. Federal Reserve Chairman Ben Bernanke has also warned that the tax increases and spending cuts will cause a sharp contraction in economic growth.
"It will be a net positive for the dollar as money flows into the greenback based on safe-haven flows more than anything else," said George Davis, chief technical analyst at RBC Capital Markets in Toronto.
Last year's bitter partisan fight in Congress over raising the debt ceiling, the legal amount the U.S. Treasury is allowed to borrow, caused the dollar to outperform the euro as investors sold stocks and other assets associated with risk and fled to government bonds.
In July 2011, the euro lost 1 percent of its value, with a 0.4 percentage-point loss in the final week of the month before the cutoff date for raising the debt ceiling.
The U.S. ultimately paid a price for the political partisanship, losing its coveted top-tier triple-A rating from Standard & Poor's. Still, the dollar gained about 0.9 percent in the week following that downgrade. Government debt prices also gained.
To be sure, a U.S. "fiscal cliff" could have such a dramatic effect on the economy and markets that the dollar could eventually weaken as capital flees to regions with more stable macro policy frameworks.
If that happens, the Federal Reserve may be forced to undertake new stimulus measures, a negative for the dollar.
Nevertheless, the dollar's status as one of the safest and most liquid assets in the world should trump those concerns. The fact that there are few large, liquid economies that currently have stronger fundamentals than the United States would stave off some of that flight.
Traditional safe-havens, such as the Japanese yen or the Swiss franc, could serve as alternatives to the dollar, but Japan is having similar issues with sluggish growth.
At the peak of the U.S. recession in 2008, the dollar appreciated 4.3 percent against the euro. Against a basket of major currencies, the dollar rose 5.8 percent.
"Should we hit another recession, the dollar could rise by 10 percent, with a 5 percent gain in December before we hit the 'fiscal cliff' and another 5 percent gain in January," Anderson said. "The shock effect helping the dollar will wear off after that."
Euro zone debt dilemma
The dollar's performance against the single currency shared by 17 countries also hinges on the state of the euro zone's three-year old debt crisis.
The euro is up 0.8 percent against the dollar so far this year, last trading at $1.3048. The euro, however, has receded from a 4-1/2 month high reached on September 17 at $1.3169.
An announcement by the European Central Bank last month that it was willing to buy unlimited amounts of bonds from highly indebted countries like Spain and Italy has helped the currency.
Expectations that Spain will eventually ask for a bailout have also quelled fears about the debt crisis, though there are concerns that the inordinate amount of debt taken on by the ECB will eventually hurt the single currency.
George Dowd, senior director, head of Chicago Foreign Exchange at Newedge USA in Chicago, said in order for the dollar to sustain gains garnered from the "fiscal cliff", the United States will need to make progress on a plan for fiscal sustainability.
"The dollar could still hold steady or gain if events in Europe deteriorate further, or if there is any escalation of military activity or tensions globally," he said.