EUR/USD: Risks relating to government debt are increasing – Commerzbank | FXStreet
In recent weeks, the foreign exchange market has turned its attention to the sustainability of G10 countries’ debt. France is once again in the spotlight, as yet another prime minister has fallen victim to the challenging budgetary situation. However, this is by no means an issue that only affects France. In the United Kingdom, a new budget will be presented at the end of November, and the market is already anxious about the potential outcomes. Last night, markets received news from the US Congressional Budget Office that the US deficit is likely to remain high at $1.8 trillion this year, Commerzbank’s FX analyst Michael Pfister notes.
US economy is weakening despite record-high deficits
“But why is this relevant for exchange rates? As we have argued several times before, the foreign exchange market has not paid much attention to public debt in recent years, at least as far as the G10 countries are concerned. However, this has now changed. The chain of effects is not easy to understand. Some readers may recall that, when the initial reports of the German fiscal package emerged at the end of February and the euro appreciated significantly, we published a chart here comparing recent spending with growth. Countries that spent more money during the pandemic were usually rewarded with stronger growth.”
“The next step – the link between stronger growth and the currency – is not quite so straightforward. Two channels of impact stand out: stronger growth gives the central bank the opportunity to pay closer attention to inflation, for example. Essentially, it can pursue a more restrictive monetary policy than would be possible with weak growth, which benefits the currency. Secondly, stronger growth leads to a stronger currency if investments in the respective country are more profitable. We have seen this in the US for a long time: a significantly higher real interest rate ultimately led to stronger demand for the US dollar because everyone wanted to benefit from the strong growth.”
“It seems reasonable to assume that the market will tolerate only so much. Deficits are already extremely high, yet governments are still unable to manage them. Furthermore, spending is no longer necessarily driving growth. In the US, for example, the economy is weakening despite record-high deficits, which means the Fed cannot ignore this and must implement a less restrictive monetary policy. Stability is also too important for the foreign exchange market to ignore disputes within Western governments over fiscal policy. This is likely to occupy us in the coming months. The fact that the options market is becoming increasingly nervous about the upcoming budget of the British government illustrates this impressively.”