Tale of Two Deficits

Conclusion:  While the long term negative nature of both the U.S. trade and budget deficits is negative for the U.S. dollar, in the short term incremental improvement on the budget deficit should be positive for the U.S. dollar, especially as European sovereign debt dysfunction accelerates.

Positions: Long U.S. Dollar via UUP; Short the Euro via FXE

“We must always take heed that we buy no more from strangers than we sell them, for so should we impoverish ourselves and reach them.”

         -  Discourse of the Common Weal of this Realm of England, 1549

In the past couple of days, the U.S. government has released the most recent information on both the trade and budget deficits.  Interestingly, the trade budget, which generally garners less attention than the fiscal deficit, was much worse than expected and in fact came in a level not last seen since 2008.  In the chart below, we’ve highlighted the trade deficit going back nine years.

Tale of Two Deficits - d1

In simple terms, of course, the balance of trade is the difference between a nation’s exports and imports.  A country has a trade surplus if it exports more than it imports and trade deficit if the opposite occurs.   Since the 1980s, the United States has consistently had a growing trade deficit.  This is both because of the low U.S. savings rate and low cost production capabilities (labor primarily) of many Asian nations.  The net result of this, particularly due to the second factor, is that many foreign nations hold large amounts of U.S. government debt to fund the trade deficit with the U.S.

There is much debate over whether a negative trade deficit is actually positive or negative for an economy.   On the positive side of the ledger, many economists point to the case of the United States where in periods of more rapid GDP growth, and perceived economic prosperity, trade deficits have expanded.  Conversely, in periods of slower GDP growth, trade deficits have narrowed. 

Regardless of the long term implications, in the short term a trade deficit is negative in the sense that it is a drag on overall GDP growth.  In May, the U.S. trade deficit was -$50.2 billion, which was a sequentially increase from the April deficit number of -$43.7 billion.  The U.S. dollar basket was down ~-9.5% over the 12-month period ending July 1st, which grew exports to the second highest quarterly on record, but this was largely offset by increased input costs, especially oil which costs the most since August 2008.  In part, this expanding trade deficit underscores our below consensus GDP growth range for the next two quarters of 1.7 – 2.1%.

While the economic implications associated with a trade deficit is subject to debate, most economists, even Keynesians, would argue that a federal budget deficit eventually becomes negative if not kept at a manageable level.  The long term budget deficits in the United States are currently front and center, especially given the debt ceiling deadline looming in early August.  Interestingly, though, the June federal budget deficit actually came in at a better than expected level, at least on face value.

In June, the estimate for government revenue is $248BN and the estimate for expenditures is $294BN, which equates to a budget deficit of $-45BN.  They key delta, as outlined in the table below, is a dramatic decline in expenditures year-over-year.  In June 2010, U.S. federal government outlays were $319BN and they declined to $294BN in June 2011.  At face value this appears positive, though according to the Congressional Budget Office literally all of this improvement was attributable to net reduction in estimated cost of loan and loan guarantees and lower outlays for equity injections in to Fannie Mae and Freddie Mac. 

Estimates For June (Billions of dollars)

Tale of Two Deficits - d2

For the year-to-date, which is the first nine months of the government’s fiscal year, the Federal budget deficit has seen limited improvement.  Based on the reported government numbers, revenue is up 8.5% and expenditures are up 4.0%, so the deficit has improved by $31BN for the first nine months to -$973BN according the government’s numbers.  That said, if expenditures are adjusted for various one-time charges (primarily payments to GSEs), the deficit is basically flat year-over-year.  Currently, the budget deficit is on pace to be just under $1.3TN for the full year and is trending just above the 9% deficit-to-GDP level.

Obviously, given this massive budget deficit, the federal government will continue to have to aggressively borrow absent a long term deficit reduction plan being passed by Congress.  The financing expense is literally being seen in the deficit results.  Net interest on public debt has grown 17.8% year-over-year in the first nine months to $202BN. So, 11.6% of federal government revenue is going just to servicing debt.

Tale of Two Deficits - d3

While both the trade and budget deficits have different long term implications, there are both critical to watch and understand as it relates to having a perspective on the direction of the U.S. dollar and U.S. interest rates.  Longer term, both suggest the case for weak U.S. dollar, though in the short term positive news flow out of the debt and incrementally positive action on the deficit should support a strong U.S. dollar, especially versus the Euro.

Daryl G. Jones

Director of Research