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Bond markets have taken in their stride the trillions of dollars in pandemic spending by governments, but investors in currency markets are getting nervous about countries' remaining fiscal firepower.

With the developed world largely out of room to cut interest rates further, investors are increasingly looking at government deficits as a gauge of currencies' fortunes; those who can deploy more fiscal ammunition will outperform.

Record low borrowing costs have so far overshadowed concerns about deficits, which tend to devalue currencies. Yet as investors reassess public finances, currency performances are starting to diverge.

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“Most central banks are getting close to as much easing as they can do. In terms of the relative importance of monetary and fiscal (policy), fiscal clearly rises,” said James Binny, Global Head of Currency at State Street Global Advisors.

The swing in focus from interest rates to deficits and debt ratios as drivers of exchange rates spotlights potential winners and losers.

Winners will include the Norwegian and Swedish crowns and the Australian dollar, which have been rallying against rivals who have relatively higher deficits and debts as a proportion of gross domestic product (GDP). Sterling, the Canadian dollar and various emerging market currencies may lag.

Even the dollar, the world’s reserve currency, may not be exempt -- Binny favors the euro against the greenback as euro zone governments have “more in the tank” than the United States to hike spending without rattling investors.

While a potential Democrat victory in November’s U.S. presidential election will likely mean more U.S. stimulus, Europe has room -- on paper at least -- to go further.

While both countries are expected to have similar debt-to-GDP ratios of around 100%, this fiscal year’s U.S. budget shortfall is projected at 16% of annual output, versus around 8.5% for the euro-wide area.

Societe Generale strategist Kit Juckes predicts a “powerfully higher euro” should Europe embark on another spending splurge. Currently around $1.17, the euro will trade between $1.20 and $1.30 in 2021, he says.

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RELATIVELY STRONG

Weak oil prices have pushed Norway into its first budget deficit for 25 years but its currency has rallied in recent weeks, helped by a small deficit and a debt-GDP ratio of below 50% .

Similarly, Sweden’s crown is benefiting from a public deficit forecast at 4.2% and a 35% debt ratio, as well as a recovering economy.

The Australian dollar has outperformed its Canadian peer this year, though both are tied to commodity prices. Australia’s budget deficit is forecast at a record 11% in the year to June but Canada’s could hit 16%.

Australia’s 25% debt ratio compares with Canada’s 31%. Australia’s is forecast to rise to around 35% by mid-2021 and Canada’s to 49% in the 2020/21 fiscal year.

CUTTING TOO EARLY

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Politicians in heavily-indebted countries are more likely to balk at further spending increases, in turn weighing on currencies, Juckes said.

“It’s about how brave you are (to increase spending) and how big (your capacity to spend more) was to begin with,” he said, expecting the fiscal question to become more dominant in 2021.

One example is Britain where Finance Minister Rishi Sunak has warned of a need to repair public finances through tax rises and is replacing a worker furlough scheme with a less generous plan.

With a budget deficit forecast at 18.9% of GDP this financial year -- levels not seen since World War Two -- and public debt topping 100%, sterling is set to struggle.

Already hobbled by Brexit uncertainty, sterling has fallen against the dollar and euro in 2020.

There are exceptions to the trend. Japan’s yen, historically viewed as a safe-haven, has strengthened as the country’s vast domestic savings have offset concerns about its 230% public debt-to-GDP ratio. The dollar is down 3% against the yen so far this year.Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.

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