NEW YORK U.S. deficit concerns returned to the forefront of foreign exchange trading on Monday, pushing the dollar lower after Moody's said a tax-cut deal reached last week by the White House and Republicans could shift its outlook on the United States' top credit rating.
A U.S. tax cut deal could swell the budget deficit at a time when the Federal Reserve is committed to accommodative monetary policy.
U.S. trade and budget deficit concerns have traditionally worried investors but they have been overshadowed in recent years by the collapse of the housing market, bad mortgages and their weight on the banking and financial system.
Now, as the economy appears to be recovering, investor focus has shifted back to the budget deficit.
"This move is coming as the market starts to price in the impact of the tax cut deal, and while Moody's saying it increases the chances of a negative outlook on U.S. ratings isn't new, traders can't help but contemplate the 'what if' scenario," said Paresh Upadhyaya, head of Americas G10 strategy at BofA Merrill Lynch.
The budget concerns follow a rise in U.S. bond yields that began last week, with the 10-year yield hitting a six-month high, though important support levels held so far on Monday.
The euro was up 1.2 percent at $1.3390, while the dollar fell 1.3 percent against the Swiss franc to 0.9679 francs, a typical safe haven. The dollar also fell against the yen, down 0.6 percent to 83.41 yen.
Volume was lower than usual as the holidays approached, and traders said the euro could run into resistance.
Some said the market was wary of getting stretched ahead of a European Union summit this week that some hope will result in a permanent support mechanism for troubled euro zone countries.
The euro's rise pushed the single currency back through the 38.2 percent retracement of the move from June to November, but three-month risk reversals hinted at euro weakness.
Three-month euro/dollar risk reversal was at -2.101 on Monday, according to Reuters data, with a bias to euro puts and dollar calls. A negative risk reversal shows greater demand for put options relative to calls and shows more options players betting the currency will fall than rise.
But the focus Monday was squarely on U.S. tax cuts.
While the tax cut deal has led many economists to upgrade their U.S. growth forecasts and boosted equities, traders say the rise in U.S. yields was also driven by debt worries.
Michael Woolfolk, currency strategist at BNY Mellon, said markets are confident the deal will indeed boost growth, and that helped lift the dollar last week.
But he said they also fear that with unemployment near 10 percent, the U.S. central bank will nonetheless press on with a $600 billion bond-buying program to keep long-term rates low. That, together with tax cuts, may swell a budget deficit already in excess of $1 trillion.
"You may see growth in the 3-4 percent area next year, but that will cause inflation." he said. "And it's going to take an act of God to get the Fed to trim its bond buying. That's what people are concerned about."
The Fed holds its last policy meeting of the year on Tuesday.
The EU's two-day summit begins on Thursday, and leaders are expected to tweak the EU treaty, paving the way to create a European Stability Mechanism from 2013, when a temporary mechanism expires.
(Reporting by Nick Olivari and Steven C Johnson; Editing by Leslie Adler)