The Fed’s rate decision last week sent a shock to the system that has left the dollar stronger on the back of a somewhat shaky outlook. The yield on US debt rose on the expectation that interest rates will be higher in the coming months. That, in turn, supported demand for the dollar as investors expect to make higher real returns on their money.
Whether or not that trend will continue depends on a couple of uncertain conditions going forward. One of the more immediate ones is the debate in the US Congress over the budget. Political stand-offs overspending have become increasingly common, which contributed to the recent credit score downgrade by Fitch. The rating agency warned that further downgrades were possible if there was another government shutdown. And the political acrimony of the time seems to suggest there is an increasing possibility of that happening.
The uncertainties pile up
A government shutdown raises uncertainty for the markets, since the momentary reduced spending can contribute to slowing the economy. Also, there is uncertainty over the impact of what kind of concessions might be made in order to reach a spending deal. Generally, uncertainty is good for the dollar, since it’s considered a safe haven.
But, uncertainty over whether the US will actually make good on its payments over time, raises the risk premium for dollar-denominated assets. In other words, the increased risk means investors have to factor in a higher cost in their return on investment. The short-term bump in the dollar is offset by an increased long-term risk. That is reflected in the rising yields.
The clouds on the horizon
The bottom line is, however, that as long as there is plenty of money, government spending isn’t much of a problem. If the economy is growing healthily, then the government has plenty of revenue and won’t have to issue as much debt. It’s estimated that the US Treasury will have to roll over around $4.7T in short-term debt over the coming 12 months. In a high interest rate environment, that means the government will have to spend a significant more on interest to finance debt. Without a commensurate increase in tax revenue, this could be a problem.
Economists have largely given up on predicting the US will have a “hard landing” this year, after being wrong about a recession at the start of the year. A recession, of course, means that businesses and people make significantly less money, and therefore pay less in taxes. If the US manages to pull off a “soft landing” as Fed and Treasury officials hope, then the debt problem can be avoided. The dollar would likely continue to strengthen in comparison to other major economies that are struggling. But if the economy underperforms government spending, then the dollar could start suffering, even if yields rise.
What the data says
The US consumer has remained remarkably resilient, despite the higher levels of inflation. This has been thanks to rising personal debt levels, however. Therefore, investors are keen to see when consumer demand might falter as people max out the amount of debt they can take on. Later today, the Conference Board will publish its latest consumer confidence figures, expected to show a slight decline to 105.5 from 106.1 prior. Above 100 is considered in expansion.
Durable goods orders, expected to be released tomorrow, are an important predictor of the economic outlook. Businesses spend based on an expectation that their sales and profits will improve, so if durable goods are negative, it’s generally seen as a sign the economy could contract. August US Durable Goods are expected to be negative once again at -1.4%, but not as bad as the prior month at -5.2%.
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