US Current Account Deficit to Widen Further

Summary

• The current account balance will likely weaken further due to:
  • A growing budget deficit and accelerating corporate investment.
  • Strong US growth and dollar.
• A weaker current account deficit is sustainable but leaves the US exposed to a reversal of the bond flows currently funding it.

Market Implications

• A wider current account reflects growing resource pressures and upside risks to inflation.
• It is therefore consistent with my expectations of no 2024 Fed cut, against markets pricing 1.7 cuts by December.

Current Account Balance Has Peaked

In this note, I argue the US current account deficit is about to widen further.

The deficit increased sharply during 2020-21 but subsequently recovered (Chart 2). The trade balance largely drove the changes (Chart 1).

The trade balance has been in deficit since 1970. The trade deficit peaked at 6% of GDP in 2005, and energy exports have driven an improvement to about 3%. Thanks to the development of shale oil, the US energy balance now has a small surplus compared with a peak deficit of about 3% of GPD in 2008.

Whether observing the external account from the perspective of the balance between domestic savings and investment or from the perspective of relative growth rates and relative prices, the external deficit seems likely to increase.

US Savings Investment Balance About to Worsen

The savings investment balance approach to the current account suggests the deficit is about to widen. There is an accounting identity linking the balance and the current account (Chart 3). The intuition is that changes in domestic demand relative to available supply tend to be reflected in the external account.

In February, I noted how strong households and businesses balances offset the worsening government savings investment balance (equal to the budget deficit). However, since then new data suggests the overall balance is set to worsen.

Starting with the government sector, the just published Congressional Budget Office projections expect the FY2024 deficit to be $408bn or 27% above its February 2024 estimate, with the deficit remaining around 6.5ppt of GDP in FY2024-25, roughly the same as in FY2023 (Chart 4). However, this is based on current budget laws. Should presidential candidate Donald Trump win the elections, there is a risk of further widening of the deficit.

As far as businesses are concerned, profits, roughly equal to business sector savings, are close to their historical high as a share of income and therefore are unlikely to increase much (Chart 5).

By contrast, business investment (roughly equal to non-residential investment) is about to pick up. In February, I noted how manufacturing construction was soaring but equipment capex was not. I expected the latter to eventually catch up to the former. High frequency data suggest the rotation from construction to equipment spending has already started, as Powell noted in his last presser (Chart 6). Also, software spending is booming as businesses adopt AI.

Finally, the household sector savings investment balance appears unlikely to improve much. The savings rate remains low in line with rising net worth and a strong labour market. Additionally, while the residential investment (roughly equal to household investment) recovery seems stalled, residential investment represents only about 3.5ppt of GDP (Chart 7).

Relative Growth and Prices Support Weaker Current Account

The second method to analyse the external balance is through relative growth and prices. The US current account balance tends to fall when the US grows faster than its trading partners (Chart 8).

The IMF projects 2024-25 world growth at 3.2%, unchanged from 2023. By contrast, I expect US GDP growth to accelerate from here, due to factors such as no fiscal consolidation and weak transmission of monetary policy tightening. The Atlanta Fed GDP nowcast for Q2 currently stands at 3%, compared with actual growth of 1.3% in Q1.

The relationship between current account and exchange rate is complex. This involves lags (the J curve) and a feedback loop (the current account balance influences the exchange rate and vice versa). Nevertheless, in real trade-weighted terms (using the Bank for International Settlements indices) the dollar is 6% stronger than before the pandemic, which supports current account weakness (Chart 9).

Most importantly, the current account only captures a subset of FX market transactions, namely transactions in goods and services. Financial flows, captured in the financial account of the balance of payments, especially securities (portfolio) and loans (other investments), tend to adjust faster than goods and services flows. The balance of payments, which captures spot FX transactions, always balances; the breakdown between current and financial accounts is a convention.

Therefore, at times the financial account has been a driver of the current account through its impact on the dollar. For instance, the EM crises of the late 1990s led to a surge in bond flows to the US, dollar appreciation, and in turn current account weakening. Currently, the widening of trade balance suggests financial flows are driving dollar strength, mainly bond flows (Chart 10). In that sense, one could argue the financial account is contributing to the widening of the current account deficit.

Bigger Current Account Deficit Sustainable

Both the savings investment balance and the relative growth and prices approaches suggest a widening of the current account deficit. Alone this is no threat to US macroeconomic stability.

A bigger deficit simply means foreigners will hold more claims on the US and the international investment position (IIP), US claims on foreign countries minus foreign claims on the US, will get more negative (Chart 11). The US, as the holder of the world currency and of the most globally integrated financial market, is not about to experience a major breakdown in financial flows, known as a balance of payments crisis in other countries.

That said, the continued trend of current account weakening suggests competitiveness issues. For instance, the US turning from a net exporter to a net importer of capital goods (Chart 2). However, these would be better addressed through a more efficient domestic business environment than through protectionism.

Also, the US is funding its current account deficit mainly through bond inflows. These could reverse quickly if markets lose confidence in the Treasury and Fed’s ability and willingness to contain the budget deficit and stabilise inflation. A reversal of capital flows in turn could sharply weaken the dollar and raise inflation. That said, because US liabilities are denominated in dollars, dollar weakening could increase the value of US assets without impacting the value of US liabilities.

Market Consequences

The weakening of the current account reflects stronger US growth and a weakening savings investment balance. The latter in turn reflects resource pressures and upside risks to inflation. I still expect no Fed cut in 2024, based on my forecast that core PCE will remain stuck around 3%, against markets pricing 1.7 cuts by December.

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Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

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(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)