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Analysis
Decision time for US deficit

Decision time for US deficit

Larger budget deficit or smaller trade deficit

by Seema Shah in London

Mon 29 Oct 2018

As issuer of the world's dominant reserve currency, the US can run up its debt without breaking a sweat – to a point. An ill-timed tax reform package and fiscal stimulus will trigger the type of negative bond market response that typically accompanies a fiscal expansion.

According to the Congressional Budget Office, the deficit in 2019 will be almost 60% higher than forecasts made before the presidential election. Federal debt is set to rise from 78% of GDP at the end of 2018 to roughly 100% by 2030. Some forecasts see it reaching that threshold years earlier.

Usually, a key concern for most countries adding fiscal stimulus of such magnitude is that markets very swiftly begin to doubt the government's ability to attract the required increased funding. This puts upward pressure on interest rates. But in the case of the US, that doubt has not arisen.

The main reason is the dollar's unchallenged role as the world's primary reserve currency: about 60% of international reserves are held in dollar-denominated assets. In addition, thanks to rising life expectancy, strong demand for retirement savings means safe haven assets, such as Treasury securities, will remain strongly bid.

The US can display economic imbalances more characteristic of an emerging market economy, or be at the heart of a global crisis, and continue to attract demand for dollar-denominated assets. However, this dynamic cannot protect the country's economy forever.

Typically, governments introduce expansionary fiscal policy during times of slowdown to kickstart the economy. Providing stimulus when growth is already strong and unemployment is at historic lows tends to be ill-timed, because it increases the chances of overheating. In the wake of stronger than expected employment data and non-manufacturing sector activity, 10-year Treasury yields have surged. This suggests those concerns could be materialising.

In the short term, a further sharp run-up in bond yields is possible, especially if economic data shows rising wage growth. However, the associated risk with a sharp sell-off in bonds is that equity markets may struggle to digest the rise in yields. Therefore, investors should be cautious. In fairness, at some point next year, I suspect concerns about overheating will fade as the strong dollar, tightening monetary policy and the trade war start to weigh on economic growth. Unfortunately, against a weaker economic backdrop, even a renewed drop in bond yields may not be enough to soothe the growing undercurrents of unease among equity market investors.

At that point, President Donald Trump could just unleash another round of fiscal spending to re-stimulate the economy. But something that may stop him in his fiscal tracks, other than the results of the mid-term elections, is the fact that increasing the budget deficit is incongruous with his primary aim of reducing the size of the US trade deficit. A bigger budget deficit will drive down national savings, and in an economy already hitting the limits of production capacity, it will flow through to greater import demand, widening the US trade deficit. The two policies are entirely incompatible. Trump must choose: a larger budget deficit or a smaller trade deficit.

Seema Shah is Global Investment Strategist at Principal Global Investors. This article first appeared on the Short and Sharp blog.

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