In a world that’s not set in 2018 and everything still makes sense, a hawkish central bank and rising bond yields would normally increase demand for a currency.
And why not? Higher interest rates mean more moolah received for holding said currency, while rising bond yields usually signals demand for higher-yielding domestic assets.
So why is the dollar barely getting any bullish momentum these days? Analysts are pointing to Uncle Sam having “twin deficits.”
What the heck is “Twin Deficits?”
An economy that has “twin deficits” means that it’s simultaneously experiencing a fiscal deficit AND a current account deficit.
Remember that a budget (or fiscal) deficit means that the government’s spending outpaces its revenue.
Meanwhile, a current account deficit means that the economy is importing more goods and services than it’s exporting. That is, it’s using resources from other economies in order to meet its own domestic consumption and investment requirements.
Some analysts argue that the two are connected in that a higher fiscal deficit would lead to a larger trade deficit as the government borrows money from other nations to finance its spending.
It could also lead to a devaluation of the local currency, since it usually takes a weaker currency to make exports more attractive and improve trade deficit conditions.
Why is having twin deficits a problem today?
Seeing twin deficits is nothing new for Uncle Sam, but relatively tight fiscal policies have been limiting budget deficit, while higher oil exports have been helping narrow down the nation’s current account deficit.
But with tax cuts poised to increase budget deficit and the non-energy component of current account deficit widening, market geeks are watching out for shifts in the twins’ dynamic.
The U.S. budget deficit is estimated at about 3.4% of GDP in Q4 2017, while the current account deficit clocked in at 2.1% of GDP in Q3 2017. 6% of GDP is already a pretty hefty deficit for a major economy, and that’s BEFORE factoring in the Trump administration’s recent policies.The tax cut deal passed in December is estimated to push fiscal deficit to 5% of GDP by 2019 and reduce government revenue by $1.5 trillion over the next decade. And then there’s the Congress’ $300 billion spending bill, which will further increase the debt burden over the next two years.
The decrease in tax revenues coupled with the increase in government spending are worrying investors who have reacted by pushing Treasury yields higher.
Meanwhile, concerns over the anti-dollar effect of higher trade deficit have become self-fulfilling and have been weighing on the Greenback.
How will this affect the Fed’s decisions?
Take note that Fed Governor Jerome Powell and his gang are planning to raise their interest rates at least three times this year, and are open to doing more depending on economic data.
If the tax cuts boost consumer spending, or if the twin deficits do lead to a weaker currency (which also tends to increase consumer spending and trade deficit), then the Fed might see inflation rates faster than its earlier estimates.
This could lead to a more aggressive tightening policy that would push Treasury yields higher and spook investors out of equities.
But if it maintains a cautious stance and shrugs off recent fiscal policy changes, then it runs the risk of firing up the already hot equities markets.
This is why we need to listen closely to what FOMC members have to say over the next couple of days. Specifically, look for signs that the Fed is getting ready to upgrade its growth and inflation projections, as well as its views on the expanding fiscal deficit.
What does it mean for the dollar?
Historically, having twin deficits alone has not shown direct impact on the dollar. The early 1980’s, for example, saw the Fed raising its interest rates and pushing the dollar near its all-time highs.
Some also point out that there are other reasons for the dollar’s recent demise. Expectations of monetary policy tightening in other major economies have attracted funds to higher-yielding bets, while Trump’s protectionist biases and tendencies to jawbone the currency have also pushed speculators away from the Greenback.
That said, the twin deficits situation is still worth paying attention to, especially if it prompts policy or bias changes for the Fed.