Why Budget Deficits Matter for U.S. Assets

• Heading into the home stretch of campaign season for the U.S. election, we sense a fair degree of complacency in the markets when it comes to U.S. public finances.
• Thus far, both Democrat nominee Harris and Republican nominee Trump have only offered rough sketches for fiscal and economic policy.
• Nevertheless, there doesn’t appear to be much weight from either candidate on what is needed right now — budget consolidation.
• Given the current starting point for the U.S. budget deficit (5.5% of gross domestic product, or GDP) and stock of debt (100% of GDP), the lack of consideration for fiscal prudence could become an investible theme soon.
• An additional complication is that the U.S. economy is not in need of large stimulus at this point. Expansionary fiscal policy (of the degree seen now) is generally meant to be counter-cyclical — when growth/​inflation are low and unemployment rates are high.
• History has shown that markets punish sustained budget deficits via two main channels: higher yields and a weaker currency.
• The link to higher yields is easy to understand — an increase in bond supply to fund wider deficits leads to higher term premiums.
• Empirical evidence also shows that persistent budget deficits in a procyclical environment should weaken the USD over time. We estimate that for every 1% increase in the budget deficit (as a percentage of GDP), the USD Index should decline by 2%.

Takeaways

• If concerns on persistent U.S. budget deficits arise, Canadian-based investors should consider hedging currency risk for U.S.-based investments.
• For example, if you’re looking at ETFs that track the performance of the S&P 500, consider the ZUE (BMO S&P 500 Hedged to CAD ETF) instead of the ZSP (BMO S&P 500 Index ETF).
• Additionally, such a scenario is consistent with the ​‘monetary debasement’ theme — which is when investors become increasingly concerned with declines in the nominal value of the USD. In those environments, Gold tends to outperform, and investors could look at ZGLD (BMO Gold Bullion ETF) or ZGLH (BMO Gold Bullion Hedged to CAD ETF).

Introduction

Though it may not seem like it anymore, fiscal prudence is still an important factor for U.S. assets over the medium-to-long term. As we approach the U.S. election, investors should not remain complacent about the risks of large and sustained federal budget deficits in the coming years.

This is particularly true given the starting points for the deficit and debt stock in the United States. For instance, the former is currently at 5.5% of GDP — which is abnormally large for peace time (see Chart 1) and with the economy still expanding close to trend. However, given the lack of public interest on the topic, we don’t expect either presumptive Democrat nominee Kamala Harris or Republican nominee Donald Trump to run on a platform of budget consolidation. Instead, the risk is that large budget deficits will persist, and potentially even expand depending on a few factors. That should keep federal debt-to-GDP (currently around 100%) on track to rise further. 

Chart 1 – The U.S. Budget Deficit Over Time (% of GDP)

However, markets won’t wait for the coming years before they reprice these risks. Indeed, empirical evidence from the past clearly indicate that sustained budget deficits in a procyclical environment (or when the economy is relatively healthy) are important in driving U.S. assets lower. In this note, we’ll key in on why a procyclical deficit matters for the U.S. dollar (USD). Based on the prior relationship, we estimate that a broad index gauge for the USD should decline by 2% for every 1% increase in the deficit. Under this scenario, investors outside of the U.S. can consider currency-hedged ETFs to ensure that adverse currency moves don’t impact returns on the underlying.

Before we begin, we’ll provide a brief background on how fiscal policy is traditionally used, alongside why the fiscal authority in the U.S. (the U.S. Treasury) routinely runs a budget deficit.

When Should Governments Run Budget Deficits…

Generally speaking, fiscal policy is meant to be used in a counter-cyclical manner. For instance, in response to poor economic conditions (when growth is slow and unemployment is high), governments will usually run a deficit by spending in excess of revenues (see Chart 2). In theory, this should help spur the private sector — households and businesses — to spend a greater share of their incomes on consumption/​investment to drive economic activity. Indeed, by running large deficits, governments alleviate the need for the private sector to do so in times of need.

Chart 2 – Traditionally, Fiscal Policy Is Meant to be Used in a Counter-Cyclical Manner

Of course, an increase in budget deficits means that government borrowing needs will rise as well. For the most part, developed market economies shouldn’t run into too much trouble raising the necessary amounts of funding via issuing bills and bonds. An important reason for this is that most developed market fiscal authorities have the credibility and reputation for prudence that lenders desire. That’s why sovereign bonds are largely seen as a comparatively lower-risk investment in many jurisdictions.

Why Things Are Easier for the U.S. Treasury

The U.S. Treasury occupies an enviable position in this eco-system as the demand for U.S. T-bills and bonds is usually high at all times – even during periods of market stress. Domestically, these instruments provide households and non-bank financial institutions (pensions, asset managers) with places to park savings and earn decent returns for extremely low risk. Within the U.S. financial system, they are used as collateral by institutions for cash borrowing needs. Outside of the U.S., there’s a massive need for U.S. dollars for various reasons related to debt servicing, trade settlement, and general liquidity amongst others. As such, it behooves foreigners to always maintain USD liquidity. Indeed, the global demand for U.S. T-bills and bonds provides an easier path for the U.S. Treasury to run budget deficits, and at a more basic level, it underwrites the considerable degree of consumption and investment in the United States.

Chart 3 – A Comparison of Budget Deficits/​Surpluses and Debt/​GDP by Country

However, even with the demand for U.S. paper and all the institutional credibility that the U.S. Treasury has generated over the past several decades, there are limits to the degree by which markets will tolerate fiscal largesse. Empirical evidence has shown that markets won’t always be keen to take sustained large budget deficits in stride – especially if it becomes clear that the U.S. government is pushing further towards challenging long-term fiscal orthodoxy. The U.S.’ enviable position has lasted decades, but by no means should it be considered sacrosanct.

One only needs to look back to the United Kingdom ​‘mini budget’ in the fall of 2022 as an example of how markets will react to a cavalier approach to public finances. Back then, U.K. PM Liz Truss’ government announced unfunded tax cuts and new spending measures for households/​corporations amidst a backdrop of elevated inflation. But underlining these announcements was the perception that the Truss government was going to challenge the independence of institutions that had been responsible for ensuring economic and financial stability. The market’s response was swift and saw U.K. gilt yields rise aggressively while the pound sterling hit multi-decade lows (Chart 4). The former was also instrumental in causing the liability-driven investment (or LDI) crisis that plagued domestic pension funds shortly thereafter.

That precedent is something to keep in mind as we look ahead to the U.S. presidential election later this year. Not least given that Republican candidate Donald Trump has already shown a significant level of contempt when it comes to existing institutional frameworks around fiscal and monetary policy.

Why the U.S. Fiscal Situation Is at a Potential Tipping Point

The upcoming U.S. presidential election represents a potential tipping point when it comes to public finances. Recently, the Congressional Budget Office (CBO) revised its projections for 2024 with the deficit expected to increase to almost $2 trillion this year (or 6.7% of GDP). Additionally, the cumulative amount of deficits over the next ten years is north of $22 trillion — and the U.S. will be running budget gaps north of 5.5% of GDP for each year over that horizon. This would mark the first time since World War II that the U.S. has run expansionary fiscal policy of this magnitude over a ten-year horizon. Indeed, the CBO projects that the persistence of deep deficits would mean an increase in public sector debt-to-GDP by an additional 23% (to 122%) over the next 10 years (see Chart 5).

Given where we are in the economic cycle — with the U.S. economy running at trend and unemployment still close to all-time lows — fiscal policy should be focused on consolidation and providing the market with a plan to balance the books. This is the wrong time to be running large deficits in a sustained manner.

Chart 4 – The Decline of the British Pound, and U.K. Gilts in Response to the 2022 Mini-Budget

Chart 5 – CBO Budget and Debt Projections as of June 2024 (% of GDP)

How This Election Could Impact the U.S. Budget Deficit

The above projections don’t take into account what both parties are planning on running on ahead of the election in November. For instance, Republican nominee Donald Trump has repeatedly mentioned that he will extend the 2017 tax cuts for households, small business, and estates for wealthy individuals (which expire at the end of next year) for another ten years. He’s also indicated that those tax cuts will both pay for themselves (meaning higher nominal growth because of them) and will be funded by new tariffs on imported goods — including 10% surcharges on imports across the board and 60% levies on imported goods from China.

However, there’s almost no credible research nor examples in recent history that conclude that such tariff measures would provide enough of an offset for revenues lost due to tax cuts. The CBO itself is a bit circumspect of Trump’s assertions and projects that the extension of the 2017 tax cuts would add $4.6 trillion to the deficit over the next decade.

For the presumptive Democrat nominee Kamala Harris, the focus is on i) a federal ban on price gouging, ii) housing affordability (via construction of new homes and subsidies for down payments for first time buyers), iii) elimination of taxes on tips, and iv) enhanced child tax credits. Of course, these are just talking points for now, but it’s reasonable to expect a potential Harris administration to fund these measures through some combination of higher corporate tax rates and allowing the 2017 tax cuts to expire. While likely not as expansionary as under Trump, the fiscal budget under Harris would still keep the U.S. fiscal picture in the red for the coming years.

Additionally, there’s still a good chance that the Harris administration is aligned with Biden on student loan forgiveness. That was a meaningful reason for why the CBO had to revise this year’s budget deficit higher. Again, how this would get funded is still up for speculation.

Indeed, it’s hard to see either party running a campaign centered around what is really needed right now — budget consolidation. That would require messaging consistent with higher taxes and lower spending which would likely not shift the balance of polls in this environment. At the very least, regardless of who wins this November, it’s reasonable to expect that the U.S. Treasury will be running deficits for some time to come and that they could remain wider than what is historically considered normal.

For markets, the implicit cost of ignoring large and persistent deficits in the U.S. is that it brings the same challenges to conventional thinking and fiscal orthodoxy that the Truss administration did in the U.K. in late-2022. That represents significant risks for markets in the coming period.

How to Gauge the Effect of Deficits on the USD

To summarize things, heading into the home stretch for U.S. electoral campaigns, the sense is that we should be somewhat concerned with the lack of attention being paid to persistent budget deficits. That’s especially true given that the voting public doesn’t regard fiscal prudence as a primary concern for this election. And while we don’t have the granularities of how either candidate would fund tax and spending measures, Trump’s extension of the 2017 tax cuts and general challenges to monetary policy orthodoxy could bring the U.S. closer to the U.K. mini-budget experience of fall 2022.

History has shown that the two main conduits for markets to punish fiscal profligacy are via higher yields and a weaker currency. The link to higher yields is easy enough to understand — an increase in bond supply to fund wider deficits leads to higher term premiums. However, the role of fiscal dominance on the USD is less clear.

As a starting point, we can look at the recent past to discern whether there are any obvious patterns between changes in the fiscal budget and the general value of the USD. Since the dawn of the fiat system for currencies, there doesn’t appear to be a strong relationship between the size of the budget deficit and the value of the USD (see Chart 6).

But what happens if we take the context of today’s deficits into consideration? For instance, we can contain the historical observations to periods where the deficit expanded in a pro-cyclical environment — or where the economy was generally doing well and not in need of stimulatory policy. That filter would put things into better context with where we are today. Prior periods that are consistent with procyclical fiscal spending include March 2002 – June 2004 (the post-9/11 increase in defense spending), and July 2022 – July 2023 (post the passage of the Inflation Reduction Act).

Chart 6 – No Real Relationship Between Budget Deficits and the USD Over Time…

Charts 7 and 8 paint a more relevant picture — with both showing an improvement over the original relationship in Chart 6. Granted, the July 2022 – July 2023 window is marred by sample size and central bank responses to the inflationary shock which implies that monetary policy differences were an important driver for the currency markets over that time. As such, our preference is to lend a bit more weight to the March 2002 – June 2004 corollary. If we regress on differences for the observations in that window, a 1% increase in the budget deficit could equate to a 2% decline in the USD Index.

Of course, these are just estimates. Nevertheless, they give us a feel for what could be in store if the U.S. continues to run sustained budget deficits in a procyclical backdrop. This is an especially important takeaway if Trump wins the election given his known preference for a weaker USD (which we’ll address in a future note). Indeed, a win for Trump would likely lead to additional risk premiums being priced into the greenback regardless of whether he has any direct ability to weaken the USD unilaterally.

Chart 7 – The Budget Deficit and USD Under Procyclical Environments

a. 2002–2004

b. 2022–2023

What’s the takeaway for our readers? If the above scenario plays out, our Canadian-based investors may consider hedging currency risk for investments in our U.S.-based ETF products. For example, if you’re looking at ETFs that track the performance of the S&P 500, consider the BMO S&P 500 Hedged to CAD Index ETF (ticker: ZUE) instead of the BMO S&P 500 Index ETF (ticker: ZSP).

Currency markets are notoriously difficult to call, but the risks are impossible to ignore in a period of USD weakness and Canadian dollar (CAD) strength. For example, the period between April 2020 – May 2021 saw the CAD appreciate by 13.5% against the USD. A Canadian investor that had elected to go with ZSP (instead of ZUE) would have underperformed over that timeframe (Chart 8).

In addition, increased concerns with persistent deficits should amplify chatter around monetary debasement. This tends to be a decent backdrop for Gold and related assets to outperform. Investors may want to consider extending exposure to the BMO Gold Bullion Hedged to CAD ETF (ticker: ZGLH).

As we get closer to the election, it’s imperative that investors pay particular attention to how markets reprice the risks of sustained procyclical budget deficits. If prior history is any indication, a serious repricing means that U.S. duration is at risk, while the USD should come under pressure. Investors should be wary of such risks.

Chart 8^* – Why Currency Hedging Makes Sense When the USD is Weaker

Table 1^* – Historical Performance of ZUE and ZSP 

^*Cumulative performance, as of July 31, 2024.

^**The inception date of ZSP is November 14, 2012, while the inception date of ZUE is May 29, 2009. 
Source: BMO Global Asset Management.

Table 2^* - Annualized Performance of ZUE and ZSP 

* Annualized performance, as of July 31, 2024.

^**The inception date of ZSP is November 14, 2012, while the inception date of ZUE is May 29, 2009.
Source: BMO Global Asset Management.