Dollars and Deficits: A Vote of Non-Confidence

posted by Karim Pakravan on March 7, 2018 - 2:03pm

In the past few months, the stars seemed aligned for a stronger dollar:  strong U.S economic growth and rising interest rate differentials between the dollar and other major currencies.  Yet, we have witnessed the opposite: the dollar (as measured by the DXY, a weighted average of the dollar relative to the currencies of the U.S. main trading partners) has weakened significantly, falling by 13.3% in the year through early March, and losing 2.3% year-to-date. This vote of non-confidence comes from the confluence of several factors:  bond markets concerns about an overheating U.S. economy and the surging twin deficits.

Fig.1: Dollar Index

After a period of relative stability in 3Q17, the 10-year T-bond yield surged by 50 basis points (bp) from mid-December to 2.80% by early March, Moreover, the US-Germany 10- year yield differential reached 230 bps and the US-Japan one to 280 bp.  Moreover, the 10-year yield and the DXY’s positive correlation switched to a negative one from the end of 3Q17 onwards.

Fig.2: TIC Data: Trend Reversal

At the same time, despite the Fed tightening and the rise in US interest rates, foreigners had begun selling (on net) U.S government bonds in the second half of 2017.  Furthermore, the U.S trade deficit, fed by an acceleration of U.S growth, rose by 12% in 2017, to $550 billion dollars and the monthly deficit increased to $56.6 billion in January from an average of $51.3 billion in 4Q2017.

Fig.3:  Dollar-Interest Rates Correlations Reverse

These trends and developments reflect in large part concerns by domestic and global financial markets over the runaway U.S. fiscal deficits. With the two latest fiscal measures (the December 2017 Tax Cuts and Jobs Act, and the February 2018 bi-partisan two-year spending agreement), the Republican Party has essentially jettisoned its long-standing balanced budget/fiscal austerity message.  In June 2017, the Congressional Budget Office (CBO) had estimated that he fiscal deficit would rise from around 3% of GDP in 2017 to 5% by 2027, while the federal debt held by the public would rise from 77% of GDP in 2017 to close to 95% in 2017—that was before any changes in the legislation.  With the tax cuts and rise in government spending introduced since the end of 2017, the fiscal deficit is projected to widen from $660 billion (3.5 %of GDP) in FY 2017 to about $1 trillion (5% of GDP) in each of FY 2018 and 2019. Furthermore, Federal debt could reach 100% of GDP by 2027.

The concerns of the financial markets have been amplified by the chaotic policymaking by the White House, as exemplified by the ill-timed and arbitrary decision on tariffs on imported steel and aluminum, as well as the resignation of a key White House economic advisor.   Ultimately, the non-confidence vote by financial markets in the economic stewardship of President Trump has been reflected in a vote of non-confidence in the U.S. dollar. That trend is not likely to change anytime soon, leading to further dollar weakness over the medium term.