The news that President Obama’s address to the nation today will outline a more comprehensive plan for dealing with the country’s chronic fiscal obesity has failed to turn the tide of negativity towards the greenback over recent days. Encouragingly, the White House seems to be finally embracing the need for drastic policy action, including meaningful reductions in healthcare and defence costs and increased taxes. For its part, the GOP has made it clear that proper fiscal surgery is required before it can justify voting for an increase in the $14.13trln government debt limit, a ceiling that looks set to be reached in the next 4-8 weeks. Some senior Senate Republicans have been urging the President to sign up to a goal of chopping the deficit by $4trln over the next decade, in an endeavour to stabilise the inexorable rise in government debt over recent years.
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Medium-term fiscal restitution ought to represent a longer-term positive for the currency although, in the short term, it is unlikely that the current downtrend will be reversed. Reflecting on previous episodes when major advanced economies have been forced to tackle fiscal largesse, invariably this has coincided with a lower currency, both in nominal and real terms. If the US government does now finally engage in proper fiscal consolidation, then the likelihood is that the Federal Reserve will keep monetary policy ultra loose for even longer.
As we have witnessed already this year, a scenario where a major central bank is set to keep the pedal to the monetary metal invariably renders the currency attractive to those traders who specialise in the carry trade. Although the dollar has drifted lower in the first few months of this year, the implementation of substantive fiscal repair at the federal level is unlikely to reverse the currency’s downtrend any time soon.
By Michael Derks, Chief Strategist