We are now only days away from the August 2, 2011 deadline for the United States to come to a decision or agreement on their debt ceiling crisis. There is some talk that the US will have enough money to last until September but either way the situation is pretty dire.

Ratings Agencies such as Moody’s and Standard & Poor’s have indicated that even if the US resolves its short-term debt worries (possibly by raising debt limits, effectively giving itself a credit-limit increase), they may still downgrade its AAA credit rating.

While the focus - quite rightly - has been on whether the US will be able to continue to pay its bills, the consequences of a downgrade could create a shockwave that would really rattle financial markets.

For as long as most traders and investors have been alive, US debt has been considered reliable, safe and virtually risk-free. If the United States credit rating is downgraded even slightly, this could be the catalyst that stirs investors to action. And that action could be horrific for the US Dollar.

George Soros (who reportedly made a billion dollars in one day shorting the British Pound in September, 1992) talks about his theory of reflexivity in the markets. Essentially, reflexivity deals with the circular relationship of cause and effect. Soros argues that once events are set in motion and a tipping point is reached, a rise or fall in the market can become a self-fulfilling prophecy.

Let’s consider this in the current climate. The US has reached its debt limit and may not be able to pay its debts. Ratings agencies are talking about downgrading the credit rating of the United States. The US Dollar has already fallen quite a long way against most currencies. So the wheels are in motion. The question is whether the tipping point has already been reached that makes the further fall of the US Dollar inevitable.

Let’s assume that the US credit rating is downgraded and look at what could follow: Confidence in the US Dollar decreases even further. Traders, investors, banks and financial institutions decide to offload some of their US Dollar holdings. The US Dollar continues to fall. More and more investors get nervous and sell off their US Dollar assets. International investors sell their US Dollar share portfolios, leaving them with US Dollars in cash which they convert back to their home currency, further pushing down the US Dollar.

This could get really ugly for the US Dollar. Even though the Dollar has been falling for the last few years against many major currencies, W.D. Gann said that the most severe moves tend to happen towards the end of the cycle. I suspect what is coming will be worse than what has already occurred.

For the Australian Dollar, the idea of US$1.30 by Christmas was unthinkable at the start of 2011 but is now looking a real possibility.

As always, stick to your money management rules, identify the trend and trade with it.

Be Prepared!

Mathew Barnes