The deficit and greenback dynamics | USAEMALL.com

Unlock the Editor’s Digest for free

Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

Good morning. Target reported weak first-quarter results yesterday and guided towards a decline in sales this year, sending shares down more than 5 per cent. The company also said it would raise some prices to offset tariffs, echoing Walmart’s comments last week. Retail earnings haven’t been negative across the board, but remember: the tariff headwinds have hardly started to blow. Email us: unhedged@ft.com

Dollar frown

All US federal budgets are important. But this year’s, currently working its way through Congress, is particularly so. In most cases, a budget that includes a positive “fiscal impulse” — more borrowing, more spending, a wider deficit — pushes cash into the financial system. That money eventually shows up as higher corporate profits, which supports higher equity prices, which can, in turn, attract foreign capital into the US and lift the dollar. US Treasury yields might rise, too, but less from fears over deficit sustainability than higher inflation expectations. 

This time, however, sustainability fears seem to be gaining real traction. That means that widening the deficit may not be good for equities or the dollar, and Treasuries might suffer more than usual. 

It is traditional to talk about the US currency in terms of the “dollar smile”. This is the notion that the dollar tends to strengthen both when the US economy is doing better than the rest of the world (for obvious reasons) and when the US economy is doing unusually badly (because if the US is wobbling, the rest of the world is probably worse, so the dollar benefits from a flight-to-safety trade). Only in the middle, when the US economy is fine and the rest of the world is thriving, does the dollar weaken. That framework may no longer apply, however. In a recent note, George Saravelos, Deutsche Bank’s head of FX research, called this the “dollar fiscal frown”:

At one extreme on the left is a fiscal stance that is too easy. This leads to a combined drop in US bonds and the dollar . . . The persistence of this pattern would be a clear signal the market is losing its appetite to fund America’s deficits and rising financial stability risks. At the other extreme, on the right of the frown is a fiscal stance that tightens too quickly, closing the deficit sharply but forcing the US into a recession and a deep Fed easing cycle. In this more conventional world, the dollar drops and bond yields rally.

While equities have recovered since “liberation day”, the dollar index is still down around 4 per cent — despite bond yields that are considerably higher, which would normally support the dollar. This suggests that, at the margin, international investors may be shifting away from US assets — the left-hand side of Deutsche’s frown. There are concerning signs elsewhere, too: 30-year bond yields are rising fast, other currencies are appreciating, and, just yesterday, a Treasury auction suffered weak demand. Under current conditions, it is possible that the market will recoil at a positive fiscal impulse it might have once found acceptable, sending bonds, equities and the dollar down together. Yikes.

The notion that a weakening fiscal impulse would harm the dollar — the right-hand side of the frown — makes sense in this environment, too. As Marko Papic at BCA Research says, US investors have become “addicted to fiscal [excesses]”. A fiscal impulse too small to keep equity prices and valuations at historical highs might push foreign investors away from dollar assets. Outflows could increase the probability of a slowdown or recession, forcing the Fed to cut rates — another drag on the dollar. This seems all the more likely now that spending is picking up in Europe, particularly in Germany. A stronger fiscal impulse abroad gives investors fewer reasons to pile into Treasuries.

So we find Deutsche’s framework sensible, but only to a degree. Yes, the bond market is sending Congress some appropriately negative feedback (and we pray the message gets through). But we suspect that the underlying global appetite for Treasuries and US equities remains healthy. As Ben Shoesmith, senior economist at KPMG, has noted to Unhedged, though yields have risen, they’re sitting at the same levels as before the great financial crisis. In other words, what we’re seeing now might be normalisation rather than revolution (chart courtesy of Shoesmith):

It would also be a mistake to assume that a slowdown is inevitable this year. We still don’t know where Donald Trump’s tariffs will wind up and what their impacts on growth will be. If anything, the economy is looking a bit too hot right now. 

It is difficult to read the fiscal tea leaves, too. At first glance, the fiscal impulse looks to be positive, but less positive than previous budgets. Yet, the timing is tricky; a budget plays out unevenly over a decade. According to Freya Beamish, chief economist at TS Lombard, the proposed tax cuts are expected to hit sooner, while the spending cuts will hit later on. In the near term, that suggests much more liquidity in markets and the economy. 

Looking at this landscape, it feels like there are few good scenarios for Congress or the market. The budget has to be stimulative enough to sustain growth — but not so stimulative that it sends Treasury yields soaring. Were Treasury yields to rise by another hundred basis points or more, that would make servicing the debt meaningfully more expensive and could force the government towards an austerity budget. That would wreck growth and bring down interest rates, and with them the dollar.

Of course, this could get so bad that it spills over into a full-blown global meltdown. If that happens, foreign investors will probably flock back to the US and the dollar. But that would be a very painful way to support American exceptionalism.

One good read

Boredom is good.

FT Unhedged podcast

Can’t get enough of Unhedged? Listen to our new podcast, for a 15-minute dive into the latest markets news and financial headlines, twice a week. Catch up on past editions of the newsletter here.