Has the recent weakness in the US dollar surprised you? Has the strength in the Aussie dollar had you scratching your head at all? To many, including your author, these moves have been counter-intuitive to some degree. So what could possibly be placing downward pressure on the Greenback and upward pressure on the Aussie?
For answers, the insightful teachings of Professor Michael Pettis are strongly recommended. In his outstanding book The Great Rebalancing, Pettis points out that: “The classic explanation of the origin of crises in capitalist systems… points to imbalances between production and consumption in the major economies as the primary source of monetary instability.”
While Pettis was giving consideration to the underlying drivers of the GFC, these same imbalances exert force on global currencies and are worth trying to understand. Pettis goes on: “Imbalances in one country can force obverse imbalances in other countries through the trade account.”
The link between domestic savings, domestic investment and a country’s current account – which is a measure of the flow of transactions between the country and the rest of the world, including trade, financial income and transfers – is not immediately clear and often counterintuitive. Pettis explains this as follows:
“Every country’s current account surplus is by definition equal to the excess of domestic savings over domestic investment. If a country saves more than it invests domestically, these excess savings must be invested abroad, and one of the automatic consequences of net foreign investment is an excess of exports over imports.”
So to recap, a country’s domestic growth is driven by three sources: (i) domestic consumption; (ii) domestic investment; and (iii) net consumption and investment from abroad – which is the current account surplus. And it is the change in the current account that acts as a force on a country’s domestic currency; an increasing current account corresponds to increased demand for a country’s domestic currency, and vice versa.
Cue the US fiscal stimulus. In recent weeks, President Trump has signed into law at least US$1.5 trillion of unfunded tax cuts over the next 10 years, as well as the recent budget deal which will add around US$300 billion of new unfunded government spending over the next two years.
This fiscal stimulus will likely increase domestic consumption significantly. At a minimum, it is a direct increase in “government consumption”, though household consumption will likely increase as well, given short-term income tax cuts for many Americans combined with a positive wealth effect from the booming stock market.
A consequence of a strong increase in domestic consumption is, logically, a significant decrease in the national savings rate. (Savings, here, meaning the difference between what the economy produces and what it consumes).
Meanwhile, there is a strong argument that domestic investment will increase. In part, this is due to the favourable tax treatment (full expensing) of new domestic capital investments for the next five years under Trump’s tax reforms.
Combining the two would result in a declining savings rate combined with an increased investment rate. This would equate to a larger current account deficit. (Ironically, this outcome is precisely the opposite of what President Trump has been saying he wants). And recall, if the US increases its current account deficit, then other economies must, by definition, increase their current account surpluses.
An increasing current account deficit would likely result in downward pressure on the US dollar in the near-term.
What does this mean for the Aussie dollar? Well, given the US economy is around 16 times larger than Australia’s, our current account is highly-sensitive to changes in the US current account.
A significant blow-out of the US current account deficit could well lead to some reduction of Australia’s. And this in turn, could explain some strength in the Aussie dollar we are currently experiencing.
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Andrew is responsible for managing the Montgomery Global Fund, ASX-listed Montgomery Global Equities Fund (ASX:MOGL) and global equity long/short strategy, Montaka Global Fund. Andrew oversees $500m in FUM.