One of the major themes for the last year that had an important influence on currency markets last year was government spending. Generally, Forex is less affected by particular policies or political situations in given countries. But recently and over the last year in particular, fiscal policy – how much the government spends – has become market moving. And economists believe the trend will only get bigger next year.

The longest ever US government shutdown ended a little over a month ago, having impacts on Forex that continue to this day. There are still data delays, and certain data that is vital for predicting the evolution of market-driving forces simply will never come out. But, the cause of the shutdown was government spending: Republicans and Democrats could not agree on how much to spend.
 

Global Government Spending Trends

It’s not just the US, of course. The UK Autumn Budget held markets in suspense and drove the pound for several months until traders got clarity on how the UK would tax and spend. The collapse of the French government and appointment of yet another (followed by his reappointment) of a Prime Minister was all about how the government could plug a hole in its spending.

Germany reformed its debt brake with the intent to increase spending on defense and infrastructure, which is expected to help increase demand for Euros. Japan’s new Prime Minister announced new spending, which has complicated the outlook for the BOJ, raising yields and weakening the yen. China is expected to announce new stimulus spending in the coming months, which is expected to support currencies in its main trading partners including Australia and New Zealand.
 

Where Is the Money Coming From?

All of this increased spending has to be financed somehow, and that affects currency markets. If governments spend more than they are taking in, this deficit spending increases the monetary base. As a result, inflation goes up, forcing central banks to raise rates to maintain price stability. The fluctuations in interest rates are the key driver of currency prices.

This worry that increased spending will lead to higher inflation is also driving demand for store of value assets like gold and silver. With most major global governments facing high debt ratios, investors are increasingly worried they will have difficulty meeting their debt commitments. As a result, they are demanding higher interest rates, particularly in long term bonds. This reduces the value of those bonds, which increases the risk of a financial crisis, as institutions that hold long term debt lose money.
 

Meeting Debt Requirements

Countries with high debt, like the US, the UK, Japan and many in the Eurozone, have to spend a large amount of their budget servicing the debt. That is, paying interest on debt that is already issued. If interest rates rise too much, the government’s interest payments will increase, reducing the funds available for operating the government. This, in turn, may necessitate borrowing additional funds. A vicious cycle of deficit spending can result, raising inflation and interest rates and potentially causing a recession.

The way to avoid that situation is for the economy to grow, thereby increasing government revenue. For this reason, economic performance could become an increasingly important metric for forex traders, as it will foreshadow interest rate movements. Central banks may be increasingly unable to control consumer prices out of fear of triggering excessively high rates that would push the government into a financial crisis.

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