The BoE's position may conflict with the Fed's

The interactions between governments, central banks, and financial markets look set to take on significantly more importance in the coming week. First up is the UK budget on Wednesday, and next is the US election on November 5^th. Either, or both, could have a huge part to play in the relationship between the fiscal and monetary authorities, none of which will be lost on the market.

The issue of so-called ‘fiscal dominance’ is important when it comes to deciding how currencies are likely to react when significant events occur within the government, such as the setting of a budget, or between the existing government and a possible new government when elections are held. A central bank that finds itself victim to fiscal dominance is pressed to accommodate excessive increases in debt. But there can also be monetary dominance when the central bank has the upper hand and so forces fiscal change on the government.

In Japan, it is argued that huge government debt has compromised the Bank of Japan for many decades with this fiscal dominance weighing the yen down. If central banks are perceived to accommodate fiscal largesse the consequence is likely to be a weaker currency. But if they fight back and, particularly if they offset such largesse with tighter policy, the currency can rally.

In the US, former president Trump is promoting easier fiscal policy via corporate tax cuts and making the 2017 temporary personal tax cuts permanent (Harris is also calling for the same personal tax change but only for workers earning less than USD400k per year). Of course, Trump would argue that his plans for higher tariffs would be a significant source of revenue but we dare say that most economists would dispute this. If fiscal policy becomes looser under a Trump presidency the reaction of the Fed could be crucial in determining whether the dollar rises or falls. If the Fed pursues a tighter policy than before, to try to cap any inflation risk, then we might expect any knee-jerk dollar rally (on a Trump win) to extend into the longer-term. But is this likely?

The Standard Bank rather doubts it and so, it seems, does the market. For while betting markets have shown a surge in wagers for a Trump win, market-based expectations of Fed policy have not budged very much in this time. If this remains the case, the dollar will be able to sustain any initial rally that we see after the election.

In the UK, the election occurred in July but it is only now that the new Labour government is releasing its first budget. Rather than suggest the fiscal laxity we might see in the US, should Trump win, the UK budget seems to be about probity, with significant tax cuts and the only notable areas of expenditure being on investment, not current consumption.

In theory, therefore the BoE’s position could be the polar opposite of that seen by the Fed. For while the Fed may, in time, have to decide whether to accommodate Trump-led fiscal largesse, the BoE will have to determine whether to accommodate tighter fiscal policy in the UK by cutting rates more quickly. If it decides to do this, it could weigh on the pound, and perhaps particularly if the Fed has to think in terms of slowing, or even stopping its rate cuts due to the election outcome and the fiscal outlook. In the Standard Bank’s view, this could put sterling/dollar on a path back to the 1.20-1.25 region, at least temporarily.

However, the Standard Bank said there would be a time element to this call. If the Fed eschews any fiscal dominance risk and tightens policy to offset budgetary easing then it is only likely to lift the dollar for a short period of time. This is because budgetary ill-discipline is more likely to weigh a currency down over the long haul even if any initial monetary offset generates temporary strength. Similarly, a government that retains better budgetary control, like the UK for instance, should see a longer-term reward in the shape of currency strength even if any initial monetary offset to the tightening of fiscal policy causes some temporary weakness first.