Bracing for the Default Storm

Remember that wake-up we talked about earlier this week that was coming? And how it started yesterday? Well, if we’re sticking with the Matrix analogy, the markets just woke up in the middle of that crazy human harvesting center, and the scramble to protect assets is underway. How do we mean?

Just as we feared and started asking questions about a few weeks ago – the weight of treasury bills as collateral is being called into question, as the CME’s first round of “collateral haircuts” go into effect today. According to the Wall Street Journal, “The increases ranged from half a percentage point for U.S. Treasury bills to one percentage point for Treasury notes and bonds.” Now, that isn’t a whole lot, but the FCMs put an additional haircut on those as well, so you may be looking at double or triple that amount in your managed account (still no follow up from the FCMs on the CME notice, however).

And if the US debt is downgraded regardless of whether or not the debt ceiling gets raised (a real possibility given all the infighting going on – would you feel real comfortable if someone you loaned money to had to argue with everyone in his family for two months in order to get approval to borrow more money to pay you back?) these haircuts on T-Bills could remain in place for the foreseeable future – and even increase.

All of this is falling squarely on the shoulders of the U.S. dollar instead of in bonds (where we would expect to see the threat of default weigh heaviest). The Dollar had stabilized since May, but is now threatening new 2011 lows, as the Aussie$, Swiss Franc, and New Zealand Dollar hit all time highs amidst reports of Asian banks shifting their focus. The ironic thing is that a default in bonds should mean higher interest rates (to lure investors back into the now riskier US Treasuries), which should favor the US Dollar over these other currencies, unless the US does a stealth default through devaluing of the US Dollar.

All in all – keep your eye on the Dollar in the coming weeks.

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