How The US Deficit Is Impacting The Euro

A weak currency, worsening government finances, high political uncertainty, rising interest rates, are the statements that Rusty Tweed says that plague the U.S government. The U.S Treasury bonds were once regarded as risk-free assets, but now, they are shaky, and the alternative that is available for investors is the eurozone debt. Investors from all over the world and especially those from Europe are minimizing risk by avoiding the U.S Treasuries over the last few months. This is going on even though there is a huge interest rate gap between Europe and the United States.

The levels of the U.S debt as expressed as a percentage of the GDP are close to rising above the Italian debt which is one of the most indebted states in the world. Since the Trump administration is spending $300 billion for new plans and tax cuts of $1.5 trillion, the fiscal deficit of the U.S is widening sharply. By next year, the fiscal deficit might top $800 billion which is almost an additional $200 billion from the 2017 deficit that stood at $665 billion.

Federal Reserve

As we see the balance sheets of the Federal Reserve shrinking, the supply of the new bonds will rise sharply. This will risk higher interest rates that will make the bond market of the U.S government to become more volatile. Bond issuance and debt levels in the eurozone are falling contrary to the story in the U.S. Additionally, the states like Portugal and Spain which used to be hit by the crisis are now enjoying upgrades in their credit ratings.

Threats to the Euro

Study growth of the economy, existing threats to the euro, and continued low costs of borrowing are making investors invest more on Euro bonds. In March, Japanese investors purchased a staggering $2.7 billion Spanish bonds. We still need havens, and if the U.S Treasuries do not stand by their word, alternatives will spring up for investors, and the euro debt will be one of the best havens. This is evident and economic analysis and credit strategists are moving along these lines.

Although it is impossible to beat the liquidity and depth of the U.S Treasury, the once haven is not what it used to be. The U.S government bond market of $21 trillion is the largest in the world, and it is the most liquid. The three biggest states in the eurozone; Italy, France, and Germany have a total of $ 8 trillion in government bonds.

Borrowing Ratio

But when you look at how the US government is borrowing; it is the only developed economy whose debt-to-GDP ratio is going to rise in the next five years according to the predictions made by the IMF. The IMF project that the debt levels of the US will get to 108% by the end of 2018, and 117% by the end of 2023.

This kind of rise will bring about the downgrade of the credit rating which the S&P Global has already warned about unless the budgetary issues are sorted out. Economists like the CEO of Haidar Capital Management which is a macro hedge fund stated that the debt dynamics of the U.S are rising ar a dangerous place.

Rising Debt

As the debt rises, we are going to see private investment walking out as well as foreign interests. The debt-to-GDP ratio of Italy is projected to fall to below 117% from 130% by the end of 2023. The next government is projected to loosen the fiscal disciple in Italy. Generally, the broader spectrum of the eurozone is a good foundation unlike what is happening in Washington.

Additionally, the quarterly current account surplus of the eurozone averaged 1% of GDP for the three quarters that end in December; this is the highest that has been seen in the euro period. This means that more savings are exiting the zone which could boost flows in bonds.

The Change that is going to be seen

 

Euro zone’s debt has foreign demand that is supported by the appeal it has attracted in a currency-hedged basis. But investors are repositioning themselves because of stronger growth and rating upgrades. This means that in case a turmoil exists in the market, there are more options for safe-havens for investors than ever before. To have a clear picture, Rusty Tweed advises us to look at BAML analysis.

The Analysis by BAML

During the 2008 financial crisis, stock returns and Treasury correlations were negative, at a significant 60%. The Treasury became the safe haven after equity prices fell while Treasury prices rose. Now, since the negative correlation is at -28%, it implies that equities and Treasuries are not going to move in opposite directions.

Now, for a preview of the bond market of the eurozone, Italy, for instance, is viewed as a risky market. Although the perception is clear, not only did they hold their ground throughout the first quarter turmoil in the market, but their prices rose.

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