Market Brief: Currency Markets Turn Jittery Ahead of Fed

Markets are caught in an uneasy equilibrium as the Federal Reserve begins its two-day meeting. The dollar is changing hands at its weakest levels since January, the Japanese yen is retreating from yesterday’s high, both the euro and pound are consolidating their gains, and emerging market currencies are broadly on the defensive as traders cut risk into tomorrow’s decision.

The scale of tomorrow’s rate cut remains deeply uncertain, but futures-implied odds on a 50 basis-point adjustment have climbed above 70 percent. This has very little to do with incoming economic data - no first-tier releases have been published - and Fed officials themselves have been under blackout conditions since last Saturday, meaning that they haven’t been permitted to speak with the media. Instead, the move upward appears to originate in two articles published nearly-simultaneously last Thursday by the Financial Times’ Colby Smith and the Wall Street Journal’s Nick “Fed Whisperer” Timiraos, with many investors believing that they amounted to a behind-the-scenes attempt to recalibrate market expectations.

In theory, the post-decision market reaction should be easy to forecast. A disappointingly-small 25 basis-point move could force yields higher and trigger a rally in the dollar, while a 50 basis-point cut should add weight to an ongoing move lower in interest rates and the greenback.

But as Yogi Berra put it: “In theory there is no difference between theory and practice. In practice there is”.

Market positioning looks distinctly lopsided. Speculators are crowded into bullish bets on risk-sensitive assets and bearish trades on the dollar, suggesting that any reaction could be exacerbated - or even reversed - by short-covering, option defence strategies, and other technical variables.

This morning’s retail sales report could realign initial conditions. A severe slowdown in consumer spending might suggest that the US economy is in deeper trouble than economists had suspected, suggesting that policymakers should bring rates down to neutral more quickly. The opposite - another upside surprise akin to the July print - could reinforce confidence in a soft landing, making a more gradual easing pace seem more rational.

Context will be important. The “dot plot” summary of economic projections will be closely examined for what it says about future policy adjustments, with both the 2024 and 2025 dots helping to set market expectations. A 2024 dot plot that shows something less than the sum total of four quarter-point moves will be interpreted to mean that policymakers intend to move cautiously. And Powell’s comments in the post-decision press conference will play a critical role in determining where the dust settles.

No longer-term forecasts should be inferred from the Fed’s action. A record of the trade-weighted dollar’s reaction to the first rate cut in each easing cycle since the early nineties (an admittedly small, and seriously flawed sample*) shows that a variety of outcomes is possible in the days and weeks ahead. Simply put: even if we knew how tomorrow’s decision would pan out, we still wouldn’t be confident in taking directional positions on it.

The Canadian dollar is drifting lower ahead of an inflation update that should keep the Bank of Canada on its rate-cutting trajectory. Headline consumer prices are seen climbing 2.1 percent in the year to August, down from 2.5 percent in the prior month, the Bank’s preferred core measures are expected to hold within the target range, and diffusion indices - which measure the number of categories generating price increases - will likely remain consistent with a decline in underlying inflation pressures.

Officials have moved decisively, and are hinting at more aggressive easing in the months ahead, suggesting that worsening domestic fundamentals are playing a more important role in determining the rate-cutting path than any concern over a “policy divergence” between the Bank of Canada and the Fed. With the risk of a re-acceleration in inflation looking increasingly improbable, the exchange rate effects that might be unleashed by bigger rate cuts seem unlikely to convince officials not to cut in bigger increments, and diminishing hopes for a solid rebound in housing market activity, consumer spending, or business investment suggest that more easing is in the offing. A steady widening in the gap between Canadian and US unemployment rates points to another bout of weakness in the loonie once Fed expectations have settled into a more stable range.

*Before 1990, the Fed didn’t explicitly target the federal funds rate. Meeting minutes were first published in 1993, statements began in 1994, the Summary of Economic Projections was added in 2007, and press conferences were implemented after every meeting from 2018. Officials managed to avoid a recession in only two of these easing cycles.

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