- Fiscal headwinds in the US are set to abate sharply at the federal level…
- …while state and local government outlays should be supportive to the economy
- In the FX markets, recent movements in options suggest downside risks to EUR/USD are mounting
US state and local governments outlays are set to rise…
The idea that the US economy will get a lift in coming months as fiscal consolidation at the federal level eases substantially is pretty widespread. However, another piece of goods news in terms of fiscal policy and the economic outlook that is generally overlooked is that state and local governments will be supportive to growth next year as their outlays are likely to start picking up after a period of severe restraint. Indeed, according to the second quarter GDP figures, state and local governments’ expenditures, which are about 50% larger than the outlays of the federal government, added 0.1 percentage point to growth. Apart from the second quarter in 2012, this marked the first positive contribution since 2009Q3. Meanwhile, employment at the state and local level has also been rising, with state and local governments adding, on average, 23K jobs per month in Q3, up from 0.5K in Q2.
…as they follow tax revenues higher
While GDP data can sometimes behave a bit erratically from quarter to quarter, we think that this is the beginning of a trend. This is because state and local government revenues have improved substantially over the past years. Indeed, according to figures from the Bureau of Economic Analysis, total nominal revenues rose by 3.5% in year-on-year terms in the second quarter. This marked the fastest pace since 2011Q2 and keeps state and local revenues, which for a large part exist out of sales and property taxes, on a clear upward trend. Although the relationship between revenues and expenditures is not always constant, government consumption and investment at the state and local level typically tends to pick up roughly two years after revenues start to improve again (see graph). While the exact turning point is difficult to estimate, we expect state and local governments to soon start to make a positive contribution to growth on a sustained basis. This is adds to the case that the economy is set to accelerate sharply in coming quarters.
Downside risks for the EUR/USD are mounting
Meanwhile, recent market movements suggest that the downside risks for the euro-dollar exchange rate are building. The options market is signalling further downside potential even after the recent correction. This year the bias in the options market was generally negative. The market tried to push further into negative territory both in spot and in bias terms but was unsuccessful. As a result, the bias rose strongly over the summer and the spot followed – with EUR/USD rising – and the move accelerated from September onwards. This move run out of steam on 24 October. The options bias moved to neutral territory and spot quickly moved above 1.38. However, the options market quickly turned negative again and the positive momentum for the euro that was built up over the previous three weeks was erased in just a few days. This suggests that investors quickly get cold feet as they approach a positive EUR bias. As the market has tested the upside and failed to push prices and the bias higher, it is now vulnerable for a strong correction in the other direction. This could play out at around the turn of the year. Triggers for this could be better US economic data and further monetary easing by the ECB. If these themes play out and the US avoids another political stalemate over the various upcoming fiscal issues, EUR/USD could move towards the 1.28 once more. A very positive sentiment towards the US would be needed to clear this level, which could come in to place during the course of next year, when evidence that the economy is accelerating becomes more pronounced, and the Fed starts to taper its asset purchases. We continue to see substantial downside for EUR/USD in 2014.