Market Brief: Currencies Stabilise As Fed Expectations Retrace

Markets are recovering their footing after slipping on a banana peel early in yesterday’s session.

August’s consumer price reading landed very close to economist expectations on a headline level, but a surprise monthly acceleration in the core measure spooked investors, triggering a surge in the dollar and a rout in equity markets and risk-sensitive currencies. Rationality eventually returned, but odds on a half-point rate cut at next week’s Fed meeting were left near 17 percent, down sharply from 33 percent prior to the report.

Longer-term repercussions seem minimal. Although expectations for a more aggressive kickoff to the Fed’s easing cycle have come down, traders remain convinced at least one outsized move will come before the end of the year, and short-term yield differentials are reverting toward pre-release norms. Most major currency pairs are holding close to Tuesday’s levels.

Data just released - the August producer price index report and last week’s jobless claims numbers - should help ratify prevailing market expectations for the Fed decision, pointing to a stabilisation in underlying inflation pressures and a continued resilience in labour markets, even as demand for new workers slows. Factory-gate prices climbed 0.2 percent month-over-month in July, and were up 0.3 percent with the highly-volatile energy, food, and trade categories excluded - which, when taken in combination with previously-reported consumer price index numbers, should put the Fed’s preferred core personal consumption expenditures index on track toward a circa-0.2-percent monthly gain. Initial applications for unemployment benefits climbed by 2,000 to 230,000 in the week ended September 7, and continuing claims rose to 1,850,000 in the prior week, pulling the four week moving average down to 1,850,750.

Europe’s central bank followed through on market expectations a few minutes ago, delivering a quarter-point rate cut and leaving forward guidance unchanged. Updated forecasts show core inflation remaining slightly firmer than previously anticipated across the horizon, with prices seen climbing 2.9 percent in 2024, and 2.3 percent in 2025, up from the prior 2.8 and 2.2 percent. Growth expectations are modestly lower, with the forecast lowered by -0.1 percentage point for this year and the next. President Lagarde’s words will be carefully scrutinised in the post-decision press conference, but - in a case of nominative determinism - still-stubborn inflation rates suggest that she is likely to remain guarded on the likelihood of further cuts in coming months. The euro isn’t exhibiting any meaningful reaction.

The Japanese yen is trading with a firmer bias after Naoki Tamura - one of the most hawkish members of the Bank of Japan’s rate-setting committee - warned rates would need to rise more quickly over the next year and a half, outpacing current market expectations. “I believe that we need to raise the short-term rate to at least around one percent in the second half of the Bank’s projection period through fiscal 2026,” he said, “That’s needed to contain upside price risks and to achieve the stable and sustainable inflation target”. One percent is roughly double current market forecasts for the end of calendar 2025, and with the US federal funds rate seen falling to 1.8 percent, implies a significant narrowing in the interest rate differential that has kept the yen under pressure for much of the last two decades.

The Canadian dollar is struggling to make headway against the greenback. With the Federal Reserve and Bank of Canada following similar trajectories, domestic bond yields have been moving in sympathy with their US counterparts for weeks, meaning that cross-border rate differentials have been fairly stable, and other factors have begun to drive exchange rate moves. Although the loonie continues to function as a “risk proxy,” moving up and down in line with changes in US equity markets, long-dormant correlations with crude prices are re-emerging, putting downward pressure on the spot rate. Inflation-adjusted prices are coming down hard as global oil demand growth slows - primarily driven by weakness in the Chinese economy - weighing on the likelihood that a renewed capex investment cycle in the Canadian energy sector can help pull the economy out of its malaise, as occurred in the aftermath of the global financial crisis in 2008. This might add to the headwinds facing the exchange rate through the end of the year.

The Mexican peso is trading almost 1.8 percent above Tuesday’s close, rising sharply after a widely-panned judicial reform bill was passed by the Senate in yesterday’s session. The law, which will expose most of the country’s federal judiciary to popular elections, is generally seen by international investors as a way to circumvent checks and balances on the government’s power, and has been a key factor in the unwinding of the carry trade that helped make the peso one of the world’s best-performing currencies during much of President Andrés Manuel López Obrador’s reign.

The currency’s rebound provides an interesting illustration of the “sell on rumour, buy on confirmation” dynamic that often animates foreign exchange markets, but the tumble in Donald Trump’s re-election odds after Tuesday’s presidential debate has also undoubtedly played an important role in reducing an embedded political risk discount.

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