Market Brief: Currency Markets Trade Mixed as Optimism Grows

The mean-reversion process that began in foreign exchange markets this summer is continuing this morning, with the dollar trading flat and other majors reversing early-year moves. A steady drumbeat of economic stimulus announcements from China is interacting with growing bets on rate cuts from the Federal Reserve, European Central Bank and other central banks to support global risk appetite, pouring rocket fuel into equity markets and risk-sensitive currency pairs, while driving implied volatility levels lower.

Inflation in France and Spain decelerated more dramatically in September than had been expected, reinforcing market bets on more easing coming at the European Central Bank’s October meeting. According to Eurostat, consumer prices inched 1.5 percent higher on a year-over-year basis in the month, while Spain saw a 1.7-percent increase, as food and energy costs slumped against a soft economic backdrop. A separate report showed consumer inflation expectations continuing to recede, with prices seen climbing just 2.7 percent over the next 12 months, down from 2.8 percent in July, and the lowest since September 2021. With policymakers clear to respond to signs of a growth slowdown, odds on a rate cut in October have climbed to 81 percent.

Euro area yields are tumbling, and rate differentials have widened against the common currency, but signs of strain in intra-euro spreads are still there. The premium embedded in French government bonds relative to their German equivalents surpassed Spain’s during yesterday’s session for the first time since 2007, suggesting that investors are growing increasingly concerned about the country’s long-term fiscal direction as political dysfunction in Paris continues.

The yen is up more than a full percentage point against the dollar after Shigeru Ishiba won the race to succeed Fumio Kishida at the head of the Liberal Democratic party, putting him on course to become the country’s next prime minister. Ishiba, seen as a foreign policy hawk and supporter of a normalisation in monetary policy, beat out Sanae Takaichi, a proponent of Shinzo Abe’s “Abenomics” stimulus policies who said it would be “stupid” to raise rates now, given the economic benefits afforded by a weak yen.

In yesterday’s closely-watched decision, Mexico’s central bankers opted to cut rates by 25 basis points, disappointing a small group of market participants expecting a more aggressive move. The Banxico’s rate-setting board voted 4-1 to reduce the overnight rate to 10.50 percent from 10.75 percent prior, narrowing the spread relative to the upper end of the Fed Funds target range to 550 basis points, down from 625 last year - but still slightly above long-term averages. In the accompanying statement, officials adopted a clearly-dovish stance, acknowledging signs of slowing growth and weaker labour market momentum, while setting the stage for further easing by saying that the “inflationary environment will allow further reference rate adjustments” in the future. The peso is up roughly a quarter percentage point against the dollar, and we think it could see further gains in the weeks ahead if Andrés Manuel López Obrador shuffles off the political stage, giving incoming president Claudia Sheinbaum room to tack toward the economic policy centre.

Yesterday’s “deluge of Fedspeak” amounted to a trickle, at best. Chair Powell, Michael Barr, Susan Collins, Neel Kashkari, Adrianna Kugler, and John Williams all managed to make appearances without making meaningful comments on the monetary policy outlook. In a more insightful speech, Governor Michelle Bowman explained her reasons for dissenting in last week’s meeting, suggesting that she was wary of “unintentionally signalling concerns about underlying economic conditions” when there are “no clear signs of material weakening or fragility,” or triggering an “unwarranted decline in longer-term interest rates” - concerns that were deftly defused by Powell during the post-decision press conference. “In light of the dissonance created by conflicting economic signals, measurement challenges, and data revisions, I remain cautious about taking signal from only a limited set of real-time data releases,” she said.

Data dissonance was on full display earlier in the day. Initial claims for unemployment benefits unexpectedly dropped to the lowest in four months, directly countering evidence of an employment slowdown found in Tuesday’s measure of consumer confidence from the Conference Board. Updated estimates of gross domestic product growth over the past five years showed the economy growing at an annual rate of 5.2 percent, 0.3 percentage points higher than previously believed, and disposable personal income was revised upward by $77.3 billion in the second quarter of 2024, putting a powerful tailwind behind consumer spending - particularly if inflation pressures continue to subside.

Ahead today: the Fed’s preferred measure of inflation - the core personal consumption expenditures index - is seen rising 0.2 percent month over month in August. A benign print might bolster odds on another outsized rate cut at the central bank’s November meeting, but a lot of water will pass under the bridge between now and then - including next week’s payrolls report and the presidential election - so directional position-taking could remain relatively muted. Canada will deliver updated gross domestic product numbers shortly, with output seen expanding at a subdued 0.1-percent pace on a month-over-month basis in July.

Note: due to other commitments (and a relatively quiet data calendar), the morning Market Brief will be paused on Monday and Tuesday, with distribution resuming on Wednesday morning.

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