This month sees the inauguration of Joe Biden as US President. The Biden administration was not only successful in winning the presidency but managed to achieve a “Blue Sweep”, where the Democrats now have control of both the US Senate and House of Representatives. This is a tremendous victory for the Biden administration as it means they can push through their policy changes a lot easier and avoid a political deadlock with the Republicans. In this installment of Your Monthly Wau! we look at the effects of a Blue Wave on the currency markets.
This change in the US political landscape is bearish over the medium-term for the dollar. The Democrats have, throughout their campaign, made it clear that they want more government involvement in the US economy. Governments across the world eased fiscal policy significantly last year in response to the unfolding crisis. At the worst point of the pandemic in April, US real disposable income was up 14% year-over-year. The trend toward further fiscal easing is set to continue with fiscal spending likely to be supercharged. Increased spending will need to be offset by additional revenue measures and so it is likely that we see a partial repeal of the tax cuts implemented by the Trump Administration which mean corporate taxes will likely rise. Nevertheless, these measures will still produce a net boost to aggregate demand. The increase in spending will widen the US budget deficit by much more than was expected under a Republican Senate. A wider budget deficit is negative for the dollar. Higher demand, via increased spending, should allow the actual GDP of the economy to move closer to its maximum potential (reduction in the output gap). This means that capacity utilisation will rise and so naturally apply upward pressure to domestic US inflation. The Federal Reserve indicated they would allow for an inflation overshoot. Rising inflation would decrease US real rates (interest rates that have been adjusted to remove the effects of inflation), that in turn is negative for the dollar as investment flows to higher interest yielding economies. See Figure 1.
The US continues to run a large current account deficit, meaning domestic savings have been insufficient to finance investment. A higher budget deficit (one where spending exceeds its revenues) is likely to widen the current account deficit even further. To finance the shortfall, foreign investors might require a higher risk premium on US assets to encourage investment. This is achieved through either higher yields and / or a lower exchange rate. With the Federal Reserve indicating their commitment to keeping interest rates low for the next few years, the dollar will need to depreciate to entice foreign investors. One of the reasons behind the dollar’s decline last year has been a the move out of the Treasury market by foreign investors. See Figure 2.
As mentioned above, the Biden campaign has pledged to raise corporate and personal income taxes to help finance this additional spending. The increase in taxes mean a lower return on capital for US investments. This may lead to the flow of capital out of US equities in the search of higher expected returns putting further negative pressure on the dollar.
It is important to remember that this additional fiscal stimulus will impact growth first, with the effect of raising inflation only later. Therefore, we could see that US growth receives a boost relative to its peers in the short term. The world is seeing a new wave of infections forcing many economies to implement tighter lockdown measures. This means that economic conditions are tough, and growth may remain weak for some time. These are important considerations when gauging the future direction of currencies. The dollar will benefit from any safe-haven flows should we see a major disruption. Furthermore, if an environment persists where global growth is weak relative to US growth, the dollar will benefit due to it being counter-cyclical. The improvement in the December Purchasing Managers’ Index (an index of the prevailing direction of economic trends in the manufacturing and service sectors) was more favourable outside the US than in the US. See Figure 3. Should the US be able to bridge the gap between herd immunity (through vaccinations) and the spread of the virus we could see US economic growth gain the upper hand.
It is likely though that the economic damage caused by COVID-19 will be significantly less than economies endured during much of 2020. The main reason being that the rollout of vaccines is improving. This should pave the way for healthy global growth this year reducing safe-haven flows into the dollar. This would reaffirm our view that we are likely to see a softer dollar over the medium term together with an improvement in riskier currencies such as the rand.