The Fiscal Cavalry Is Coming: What To Expect For FX?

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Markets are increasingly shifting focus from monetary to fiscal policy. Yet the currency impact of fiscal policy is typically more complex. We set up a simple framework to think about the relationship and apply it to the G4 currencies.

The FX impact of fiscal easing is most bullish if five conditions are met: (1) negligible “Ricardian equivalence” and a high multiplier allow for a meaningful aggregate demand boost, (2) the central bank tightens policy in response, (3) a growth-oriented, infrastructure-heavy package raises the terminal real rate, (4) credit risk premia remain stable, and (5) the currency is more sensitive to higher real rates than to the associated current account deterioration.

In the US, any post-election fiscal stimulus will likely be bullish for the dollar by virtue of allowing the Fed to normalize policy faster and to a higher terminal rate. A sustainable debt level should prevent a spike in credit risk or a “Ricardian” response domestically. Capital inflows should dominate in driving up the dollar even though the current account would likely deteriorate. A potential tax repatriation holiday would provide an additional boost.

In Japan, fiscal easing should remain neutral for the yen. Monetary policy will stay accommodative, but the demand and growth impact will be limited by “Ricardian” households. Credit risk premia should prove stable, and rising debt won’t fuel inflation expectations absent signals of debt monetization. If demand did rise, the yen would be vulnerable to current account deterioration.

In the Eurozone, the impact of fiscal easing depends on the national distribution. Infrastructure spending in core economies or via a centralized programme could be bullish in permitting the ECB to exit unconventional policy sooner and lift the terminal real rate without raising the credit risk premium. The more bearish, if less realistic, scenario is significant fiscal “slippage” in the indebted periphery, which could lock the ECB into unconventional policy, lower core rates and trigger renewed outflows.

In the UK, the pound would likely strengthen if Treasury not only slowed down on fiscal tightening but spent actively on housing and infrastructure. Neither risks around default or debt monetization nor “Ricardian” behaviour should come into play. Real rates would likely rise and dominate the currency impact against any deterioration in the current account, to which sterling is insensitive.


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