Market Brief: Currencies Stabilise as Inflation Data Looms

CalendarMay 13, 2024

Foreign exchange markets are holding steady this morning as traders take cover ahead of a series of critical inflation reports that could determine the outlook for rate cuts from the Federal Reserve this year. The dollar is little changed against its major rivals, Treasury yields are moving sideways, and North American equity futures are pointing to incremental gains at the open.

Today’s Survey of Consumer Expectations from the New York Fed is likely to echo Friday’s equivalent from the University of Michigan, with inflation expectations rising toward a six-month high. Household views on inflation tend to follow changes in gas prices more than the consumer price index itself, despite the fact that energy costs make up a diminishingly-small share of overall household consumption.

Tomorrow’s producer price index is expected to show core input costs climbing 0.2 percent month-over-month in April, matching the previous month’s pace as increases in selected commodity categories intersect with the disinflationary impulse delivered through declining Chinese manufactured goods prices. A miss could cause economists to revise forecasts for the Fed’s preferred inflation indicator - the personal consumption expenditures index, due at the end of May - upward or downward, and trigger market turbulence.

Wednesday’s core consumer price index is seen slowing slightly. The measure - which excludes highly-volatile food and energy prices - is believed to have risen 0.3 percent in April from a month earlier, down from 0.4 percent in March. This would bring the year-over-year increase to 3.6 percent, the smallest in three years, but still well above the Fed’s 2 percent target. We think inflation remains in a down-trend, as cooling growth in the economy helps mitigate price pressures over time, and as shelter cost increases subside - a development that should put rate cuts back on the agenda, and limit the dollar’s yield premium.

But the last few months have brought an unmistakable rebound in the degree to which US price data has topped consensus expectations. The country’s inflation surprise index has sequentially jumped in comparison with its global counterparts, putting upward pressure on relative yield differentials as Fed rate projections have shifted. Chair Jerome Powell, speaking after the central bank’s last policy meeting, said “We don't like to react to one or two month's data, but this is a full quarter and I think it's appropriate to take signal now, and we are taking signal. And the signal that we're taking is that it's likely to take longer for us to gain confidence that we are on a sustainable path down to 2 percent inflation”. Another upside shock could easily force officials to raise the median “dot plot” policy rate projection when they meet again next month.

The retail sales number - due to land simultaneously with the consumer price index report - could prove unusually impactful. With real income gains beginning to slow and consumers running out of excess savings, the outlook for household spending is darkening and economists broadly expect a slowdown - but savings rates are declining as buyers tap credit lines, and paper wealth has kept rising in line with housing prices and stock market indices. As many battle-scarred market veterans can attest, it remains dangerous to bet against the American consumer.

Foreign exchange markets are exposed. A combination of hot inflation and rising retail sales might generate further gains in the greenback, while the opposite - slowing inflation and falling retail sales - could weaken it. A more mixed outcome - especially one in which price increases outpace consumer spending - may generate a rise in “stagflation” headlines, killing market sentiment and delivering losses to risk-sensitive currencies like the Canadian dollar, although in our (perhaps pedantic) view, true stagflation is only possible when unemployment is also marching higher.

Canada’s currency has struggled to push higher after last week’s sharp jump in headline employment gains, with market participants remaining largely convinced the Bank of Canada will deliver a rate cut in June. This morning’s building permits data could see views shifting somewhat, with a stronger-than-expected print possibly lending further credence to our “dead cat bounce” thesis, while a sharp - and on-consensus - drop might reinforce expectations for a sustained economic slowdown. Wednesday’s housing starts and Friday’s construction investment data will have similar effects.

The pound failed to gain much strength from Friday’s surprisingly-positive gross domestic product report and is marking time ahead of tomorrow’s labour market data, with wage gains coming into particular focus for central bank watchers awaiting a summer rate cut. The euro is gaining amid a paucity of domestic drivers, with the dollar’s subdued price action contributing to mild market gains.

The Japanese yen is tracing lower even after the Bank of Japan reduced its regular purchases of government bonds, pushing the 10-year yield closer to the 1 percent threshold and narrowing yield differentials relative to other currencies. The central bank said it would buy 425 billion yen in this week’s operation, down from 475.5 billion in the prior week, forcing other buyers to soak up additional supply, and suggesting that authorities are reaching for other tools to arrest the currency’s long downward descent.

But after repeated - suspected - intervention efforts, the yen’s downward momentum is turning less negative. Friday’s Commitment of Traders report from the Commodity Futures Trading Commission showed large speculators trimming their net futures bet against the yen sharply in the two-week period ended last Tuesday, while the long position on the dollar also dropped, suggesting that the steamroller is beginning to slow.

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Karl Schamotta

Karl Schamotta

Chief Market Strategist