NEW YORK (Reuters) - Fear the United States will lose its AAA credit rating or even default on its debt is driving foreigners away from U.S. assets, and the dollar is taking the biggest hit.
While stateside investors predicted lawmakers would avoid default with a last-minute deal to raise the government's $14.3 trillion (8.75 trillion pound) borrowing limit, foreigners were hedging their bets.
Recent trading in currency markets indicates overseas investors have been voting with their feet. They have also been giving short shrift to recent Treasury auctions.
Traders say Asian central banks, among the world's biggest dollar holders, have been steady buyers of alternatives to the dollar such as the Singapore dollar and other Asian currencies as well as the Canadian, Australian and New Zealand dollars.
"Foreigners are at the vanguard of the drop in the dollar," said Dan Dorrow, head of research at Faros Trading, a currency broker/dealer in Stamford, Connecticut. "I don't think anyone expects a catastrophic U.S. default. But a downgrade will make them more aggressive in moving away from the dollar."
A majority of economists polled by Reuters this week think the United States will lose its prized AAA rating from at least one of the three big ratings agencies even if lawmakers strike a deal on the debt ceiling and avoid default.
If global investors lose faith in the dollar, that could weaken its dominant position in global trade and its role as the world's reserve currency. Over time, diminished demand for dollars would make it harder for the United States to finance itself at low interest rates.
Foreign distrust of the dollar is nothing new. Record low U.S. interest rates have shaved 9 percent off its value since 2010, and economists expect a high debt burden and the strain of recovering from the financial crisis to keep unemployment high and growth slow.
That's a big concern for Asian and Middle Eastern central banks, which have long talked of reducing reliance on the greenback. China is thought to hold 70 percent of its more than $3 trillion in foreign exchange reserves in dollars, making it especially vulnerable to a decline in the greenback's value.
The debt ceiling debate has simply brought into sharper focus America's strained finances and politicians' inability to address them.
As Richard Bernstein, former chief investment strategist at Merrill Lynch who now heads Richard Bernstein Advisors, put it: "It is becoming very clear that politics is more important than the future of the American economy."
The budget gap is set to hit $1.4 trillion in the year ending September 30, one of the highest as a share of output since World War Two.
"The U.S. is experiencing an 'end of empire' moment and the dollar share of global reserves is likely to fall gradually," said Jim Leaviss, head of retail fixed income at M&G in London, with some $327 billion in assets.
So far in July, the dollar has lost ground against a vast array of currencies. It's down nearly 5 percent against both the New Zealand dollar, a high-yielding but high-risk currency acutely sensitive to swings in global growth, and the Swiss franc, a safe haven to which investors run in times of stress.
Gold, another safe haven, keeps setting record highs.
The Treasury market has held up better than the dollar, but bonds haven't been let off the hook entirely.
Foreigners, who hold nearly half of outstanding Treasury debt, have been less active buyers at auctions this month.
Still, the 10-year yield has held below 3 percent for most of July, less than a percentage point from its multi-decade low.
That's partly because domestic investors have picked up the slack in recent debt sales, suggesting they see no alternative to U.S. government bonds even in the face of a default or possible downgrade.
Indeed, analysts say even with a downgrade, Treasuries would remain the benchmark for world fixed income markets, as Fitch Ratings noted this week.
Sluggish U.S. growth, low inflation and record low benchmark interest rates also serve as anchors and enhance Treasuries' appeal to domestic buyers, as do concerns about debt problems in Europe.
Terry Belton, global head of fixed income strategy at JPMorgan Chase, said a downgrade would probably add just 5 to 10 basis points to yields in the short run.
But it could cost the U.S. government up to 70 basis points, or about $100 billion, in added borrowing costs over time as foreigners look to invest their money elsewhere.
"The wild card is what it does to foreign sponsorship," he said. "Anything we do to damage that sponsorship is potentially very damaging to how Treasuries trade over the long run."
Asian policymakers wouldn't be able to unload all their Treasuries, even if they wanted to. China and Japan own more than $2 trillion in Treasuries between them, and no other market can absorb all that money.
But they can stop adding aggressively to their stash. Traders say Asian central banks have been among the most active buyers of euros throughout the euro zone debt crisis, snapping up the single currency at a discount and adding more euros to their portfolios.
China has also been loosening its hold on the yuan, which has hit record highs against the dollar for six straight days. That means Beijing doesn't need to buy as many dollars to manage the exchange rate.
Statistics Canada reported recently that foreigners added C$15.44 billion (9.85 billion pounds) in Canadian securities to their portfolios in May, the most recent month for which data was available. That was the highest total so far in 2011.
Canada also attracted solid demand for C$2.5 billion in 10-year government bonds on Wednesday, which analysts said was partly driven by concern about the U.S. debt ceiling standoff.
"It won't take a lot of money from a reserve diversification perspective to push the Canadian dollar higher," said Jack Spitz, managing director of foreign exchange at National Bank Financial in Toronto.
The U.S. dollar had lost about 1.5 percent so far in July and was last at C$0.9492.
Singapore's $300 billion state-run investment fund, GIC, recently said it had made a shift towards emerging market assets while cutting exposure to U.S. assets to 33 percent from 36 percent. It also cut its euro exposure to 12 percent from 16 percent.
"There's a lot of hubris in the belief that whatever the U.S. does, everyone will always buy Treasuries because there is no alternative," said Douglas Borthwick, managing director at Faros Trading. "I just don't think that's true."
Additional reporting by Claire Sibonney in Toronto and Sinead Cruise in London; editing by Burton Frierson and Leslie Adler