Market Brief: Currency Markets Run Out of Momentum in Countdown to Jackson Hole

A three-week decline in the dollar appears to be nearing exhaustion this morning, suggesting that traders are growing sceptical of Jerome Powell’s willingness to “out-dove” market expectations in Friday’s appearance at the Jackson Hole economic symposium. The most widely-tracked dollar index, the DXY, is holding steady after falling in the last three sessions, Treasury yields are moving sideways, and North American equity markets are setting up for a mixed open.

We think the Federal Reserve chair could double down on July’s post-decision messaging on Friday, suggesting that it will “soon” be appropriate to begin easing policy. He might also acknowledge a more “balanced” outlook for the US economy, with downside risks in labour markets beginning to offset the possibility of a re-acceleration in inflation. But with a number of cross-currents muddying the central bank’s view of underlying fundamentals, he is likely to avoid delivering anything resembling forward guidance, instead suggesting that the central bank will proceed cautiously, gradually removing the restrictiveness implied in current policy settings as incoming data permits. This could disappoint market doves, unless their hopes are diminished first.

The Canadian loonie is trading with a firmer bias against the dollar after yesterday’s July inflation release left policy expectations essentially unchanged. Growth in the all-item price index fell to a three-year low, the core measures preferred by the Bank of Canada decelerated month-over-month, and shelter costs slowed, but this was largely anticipated by investors - overnight index swap pricing had already moved to incorporate three rate cuts by year end, with another three to follow in the first half of 2025 - and market focus has already shifted toward other fundamental measures of economic health. After more than a year in which unemployment has ground higher, the housing market has flatlined, and consumer spending has remained tightly constrained, a lot of bad news has been priced into the exchange rate, suggesting that the near-term currency outlook might be slightly more constructive than many market participants currently assume.

The euro remains close to a one-year high as rate differentials narrow in the currency’s favour, with the European Central Bank seen delivering 143 basis points in easing over the next year - against more than 190 from the Federal Reserve. Gains could accelerate if tomorrow’s bloc-wide wage numbers show pay growth holding steady in the second quarter, implying a more gradual disinflationary trajectory and a slower pace of rate cuts.

The pound is holding marginally above a key psychological threshold, but consolidative trading patterns are kicking in, with the currency’s world-beating rally beginning to lose momentum in the countdown to Friday’s denouement in Jackson Hole. Domestic fundamentals are taking a back seat to broader flow dynamics, meaning that Powell’s comments could determine whether the sterling-dollar exchange rate carves out a trading range in the 1.30’s, or slips back into the 1.20’s once again.

The economic data calendar should heat up today with this morning’s annual benchmark revision to non-farm payrolls numbers and this afternoon’s release of minutes taken during the last Fed meeting. The Bureau of Labor Statistics is expected to lower previous estimates for job growth by somewhere between half a million and a million positions in the year ended March 2024, with a bigger-than-anticipated writedown potentially bolstering calls for a speedier reduction in policy rates. July’s Fed meeting record will be somewhat stale - a disappointing jobs report landed two days after the decision was released - but could reveal the extent to which officials felt policy settings were too restrictive at the time.

Taken in combination, currency markets are following “dollar smile” dynamics. Under the theory, originally advanced by Stephen Jen at Morgan Stanley, the dollar tends to rise (toward the ends of the smile) during periods of outperformance in the US economy - when US growth is rising and the Fed is tightening - and during episodes of risk aversion in global markets - when investors repay dollar liabilities and buy Treasuries - but tends to fall (toward the bottom of the smile) when volatility falls and global growth rates converge under more normal circumstances. If historical patterns hold in the coming months, the dollar regime shift could continue, driving a decline from currently-overvalued levels - but the path there will be bumpy, and vulnerable to reversals in the event that the US economy decelerates at a faster-than-anticipated pace.

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