If US defaults, it would have lasting effects

09:32, August 01, 2011      

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The US debt crisis has developed so slowly that it hardly seems fair to call it a crisis. A crisis often develops quickly, catching participants by surprise. The US debt crisis has moved in slow motion and markets have been given plenty of time to adjust to the by now almost inevitable downgrade of US debt. The detail of the resolution remains unknown and the core problem of long term profligate spending remains unresolved.

The details of the agreement will drive short-term market reactions. The longer-term market reactions have already been incorporated into market behavior. They appear as patterns of support and patterns of continuation. They are seen in the US Dollar Index chart, the behavior of the price of gold and the behavior of the Dow Jones index. These patterns contain no surprises so investors can position themselves for profit or protection.

The US Dollar Index chart remains in a primary downward trend. Strong support/resistance is near $0.745. A negative reaction will test the longer-term support near $0.715. A sustained breakout above $0.765 is required before the downward trend is proved to be broken. The chart pattern suggests continued weakness.

Counter to this behavior is the strong trend in the COMEX gold price. The initial upside target is $1,640. This is calculated using the width of previous trading band behavior. A sustained breakout above $1,640 has a higher calculated pattern target of $1,740.

Although gold grabs the headlines, smarter investors use silver for protection. The chart pattern targets for silver show a potential rise from $40 to $48 and deliver a 20 percent return.

The Dow index has developed several almost contradictory patterns of behavior. This diversity of patterns underlines the uncertainty in the market. The head-and-shoulders pattern, which indicates an upward trend reversal, was invalidated as the index rose above 12600. This pattern has been replaced by a broad sideways movement with support near 11900 and resistance near 12800. Volatility is high within this consolidation band. This suggests the market is no longer terrified by the prospect of a US debt default, but the market remains uncomfortable.

Does a US debt default matter? The answer seems obvious, but for many Americans accustomed to a lifetime of debt, this is just one more unimportant step similar to defaulting on a credit card, a mortgage payment or a bank loan. It's no big deal because they believe international investors have limited choices when it comes to the security and safety of US Treasuries. They forget that the US dollar stood in the wings as the British pound and UK treasury 'gilts' slipped from global dominance. Today the yuan stands in the wings although conditions are not yet ready for a rapid assumption of a role as a global reserve currency.

For global economics and markets it is much more significant because a default broadens the concept of sovereign risk. The US may be able to survive a debt default, but it cannot escape the fact that it has defaulted. This changes the global economic landscape.

If US Treasuries are not AAA-rated, then they are no longer "risk-free". There is no longer a "risk-free" investment instrument and this irrecoverably alters economic thinking. The threat by Standard &Poor's and others to downgrade the United States' top-tier AAA credit rating means the "risk-free" benchmark that underpins much of economic theory and investment analysis from options pricing to modern portfolio theory is no longer valid. The new Basel bank regulatory systems assume Treasury securities are "risk-free" and if this concept is fundamentally altered then it affects the effectiveness of regulatory responses to the global financial crisis.

The key short-term indicator will be movement in the London Inter-Bank Overnight Rate (LIBOR). A spike in LIBOR effectively freezes bank lending and it was this and its effect on company debt rollovers that accelerated the impact of the global financial crisis in 2008.

US default is not a short-term event with limited consequences. The effect of debt defaults and downgrades will be long-lasting because it attacks the confidence that underpins fiat currencies that are not backed by gold. In the short term investors can anticipate exceptional volatility.

The author is a well-known international financial technical analysis expert.

Source:China Daily
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