Market Brief: Currency markets enter consolidation mode

Currencies outside the US are in consolidation mode. The Japanese yen is holding near the 153 threshold as traders turn more sceptical on the Takaichi administration’s capacity for delivering fiscal and monetary stimulus, the euro is treading water in line with an ebbing in French political headlines, and the British pound is inching higher amid a lack of domestic rate catalysts. The Canadian dollar—stuck in a narrow technical trading range for days—is moving sideways ahead of a speech from Bank of Canada Deputy Governor Carolyn Rogers, and the Mexican peso is pushing higher as optimism surrounding trade relations with the US provide buoyancy and carry trade flows deliver a consistent bid.

A record of the Federal Reserve’s last meeting showed policymakers expressing conflicted views on the path for inflation, employment, and interest rates ahead. According to minutes taken during the central bank’s September discussion, “Most judged that it likely would be appropriate to ease policy further over the remainder of this year,” given that many saw “downside risks to employment as having increased” between meetings. However, “a majority of participants emphasized upside risks to their outlooks for inflation,” and “some” noted that financial conditions indices are suggesting that monetary policy “may not be particularly restrictive,” warranting a “cautious approach” to cutting in the months ahead. A narrow majority favoured easing at least twice more in 2025, but Trump appointee Stephen Miran was alone in projecting a series of emergency-style cuts ahead. Seven of the nineteen voters on the committee were in favour of leaving policy unchanged, including one who thought borrowing costs should climb by year-end.

The dollar is tracking a renewed widening in favourable rate differentials. On a trade-weighted basis, it has moved largely sideways since early summer, but has edged higher since bottoming out around the September Fed meeting as firmer data and a consistently cautious tone from policymakers have combined to push back against market expectations for imminent easing. We suspect this process has further to go—signs of a reacceleration in American growth are likely to conflict with more bearish indicators for months yet—and the dollar could climb further before gravity reasserts itself.

More broadly, the US economy appears to be caught in a virtuous cycle. Equity markets are surging, affluent households are enjoying outsized gains, and the resulting wealth effects are bolstering retail spending, consumer confidence, and overall demand. Economists at the Boston Fed note that since 2022, real spending growth has been driven primarily by high-income consumers, who still have ample “headroom” to draw on accumulated assets and unused credit lines. According to Moody’s, the top 10 percent of earners now account for nearly half of all consumer spending.

But this virtuous cycle could quickly devolve into a vicious one. The majority of American households—those in the low- and middle-income brackets—remain far more constrained, facing stretched credit, slowing wage growth, and rising employment concerns. Should an unexpected shock erode the paper wealth concentrated at the top, the resulting pullback in high-income consumer spending could reverberate through the economy, tipping it into a deeper downturn.

Why might this prove relevant for currency hedgers? Despite an explosion in claims to the contrary, the dollar remains just as dominant in currency markets as it was in the early nineties, and we think the ‘dollar smile’ rubric for understanding foreign exchange market dynamics remains largely intact. If a correction in richly-valued equity markets unfolds, the greenback could surge against its rivals as participants unwind cross-border debt exposures and seek liquidity. Building "tail risk" protection against unexpected moves is an entirely reasonable response to today's market conditions.

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