The specter of rising debt is hurting the dollar

The initial reaction to the cut in the US debt rating by Moody’s was surprisingly small, but the following days brought a noticeable weakening of the dollar. In the background, we have a law increasing the US budget deficit and a new customs issue. 

On Friday, there was a bit of confusion on the markets, as Donald Trump once again “revived” the customs issue, threatening to impose a 50% tariff on all imports from the European Union on June 1 if a trade agreement is not signed by then. This date was postponed to July 9, but this time the market reaction was very small compared to what we saw in early April. Investors clearly considered that this should be treated as part of a “negotiation tactic,” and the sharp rebound in the markets after the sell-off in early April meant this time a reluctance to get rid of stocks. At the same time, however, it is a reminder that the trade turmoil has not disappeared and even if high tariffs do not finally come into effect, we are still dealing with an increase in tariffs, which could have stagflationary consequences for the global economy.

On the other hand, the dollar is primarily harmed by the vision of an apparently inevitable increase in the US deficit and debt. Republicans went into the previous elections with the slogan of limiting spending and healing public finances, but the opposite is happening. Last week, the House of Representatives pushed through a bill extending tax cuts and adding new ones by a mere single vote, which has now gone to the Senate. Hopes of forcing greater spending cuts (or making tax cuts dependent on them) turned out to be vain, and in the Senate, some Republicans want to add more tax cuts. It is obvious that both savings in the administration (the famous DOGE project) and revenues from tariffs (especially in a situation where tariffs will not be as high as the president originally announced) are far from sufficient to reduce the deficit.

As a result, we are dealing with the prospect of a permanent deficit of 6-7% of GDP, and this with a well-functioning economy. Even without a recession, such a deficit means a debt path that is impossible to maintain in the long term. The American administration has two options: tolerate higher inflation (which would mean higher nominal tax revenues and a higher denominator in the debt/GDP ratio) - remember that next year the president will choose a new head of the Fed, or persuade the Fed to launch another debt purchase program, which would require an economic slowdown. Neither scenario looks overly optimistic from the point of view of the dollar, and it is losing value despite the Fed's relatively hawkish stance at the moment.

This week, the most interesting events have been scheduled for Wednesday evening - the minutes of the Fed meeting, as well as Nvidia's quarterly report, which kind of closes the earnings season for us.