EUR/USD: how will a rise in US external debt affect EUR/USD? - Natixis

Analysts at Natixis examine the effect on EUR/USD in a rise in US external debt.

Key Quotes:

If the US external debt increases: 

• In the short term, an increase in dollar interest rates relative to interest rates in the rest of the world increases demand for US external debt (demand for assets issued in the United States and held in the rest of the world); 
• Longer term, if the US external debt continues to increase, the only balancing mechanism is a depreciation of the dollar, which reduces the value in the rest of the world’s currencies of the US external debt, which is denominated in dollars.

The US external debt ratio will continue to rise. The above shows that, in the short term, this increase in US external debt may be offset by an increase in the dollar-euro yield spread.

But once the dollar-euro yield spread has stabilised, and if the US external debt ratio continues to rise, equilibrium can only be achieved if the dollar depreciates against the euro.

The dollar’s depreciation against the euro then returns the market for US external debt to equilibrium by reducing the foreign-currency value of the US external debt, which is in dollars, which makes it acceptable for non-resident investors."