Market Brief: Dollar advances as rate differentials remain positive

The dollar is trading on a stronger footing ahead of a producer price report that could lend further support. Firmness in the components that feed into the Federal Reserve’s preferred inflation measure—airfares, healthcare, financial services and insurance—might lift expectations for the core personal consumption expenditures deflator, due later this month, toward the 3.3% mark, reinforcing the case for tightening.

Expectations for the Federal Reserve's policy trajectory were ultimately left unchanged by yesterday's inflation report. Sharply higher gas prices were the primary driver, with energy accounting for more than 60% of the monthly rise—enough to keep headline inflation moving in the wrong direction and justify a shift away from the easing bias the Fed has maintained since last September, but not enough to alter the rate outlook. Two-year Treasury yields moved just a few basis points, and traders still expect at least one hike this year.

There is still very little evidence that the commodity shock is transmitting into underlying measures, meaning the hike priced in for this year may yet prove to be a mirage. Strip out energy, and the picture looks far more benign. A resolution in the war could see markets revert to expecting an easing cycle—and trigger a sharp downward move in the dollar.

Oil prices are declining even as the conflict between the United States and Iran intensifies—a sign that traders are downplaying rapidly-declining inventories as they bet on an imminent peace agreement. American forces struck Iranian surveillance capabilities, communications infrastructure and air-defence sites overnight, and President Trump warned that far heavier strikes would follow—“we'll bomb the sh*t out of them”—if Tehran does not agree to a deal today. Iran's Revolutionary Guards said they had retaliated against 18 US military targets across Bahrain, Jordan and Kuwait, including the Fifth Fleet, and Tehran's newly formed strait authority declared the Strait of Hormuz closed until further notice*.

The euro is holding steady ahead of this morning's European Central Bank meeting, at which policymakers are expected to raise the deposit rate to 2.25% from 2%—the first increase in three years. The hike itself is fully priced in, along with a second in September and a third early next year, which limits the scope for a sharp upward move in the currency on the decision alone. The main event will be President Lagarde's press conference, where traders will be listening for any signal as to whether the tightening cycle has further to run or whether officials view today's move as a measured adjustment to a one-off shock. Unexpectedly-cautious rhetoric could lead the exchange rate lower.

Yesterday's Bank of Canada decision did little to alter the loonie's risk profile. Officials acknowledged the dilemma they face and pledged to remain cautious and nimble. Governor Macklem repeated language that skewed hawkish, warning that a broadening in inflation pressures could force “consecutive” rate increases, even as he noted that further easing remains on the table if the economy continues to weaken.

But the hawkishness felt somewhat performative**. In the statement, officials said they expect the economy to remain in "excess supply"***—implicitly arguing that slack will contain price pressures—and reiterated their intention to look through the first-round effects of higher energy costs, citing limited evidence of broad-based passthrough. The Bank is betting this remains a supply shock, not the start of something more persistent. We are inclined to agree, and think the rate rise still priced in for this year looks difficult to justify. Without a resolution in the Iran war, the Canadian dollar will remain under pressure.

Neither the Canadian dollar nor the Mexican peso moved meaningfully after President Trump yesterday suggested he would not renew the USMCA trade agreement at its July 1st review—a sign that markets had largely priced in the outcome. Business leaders and investors have long anticipated that the administration would use the review as leverage rather than sign an extension, and the rhetoric, while characteristically blunt, contained no new threats. Speaking to reporters in the Oval Office, Trump said “We don’t need anything that Canada has, we don’t need anything that Mexico has, but they need everything that we have … We don’t need their cars, we don’t need their lumber, we don’t need their energy, we don’t need anything that they have”. The agreement will now revert to an annual review process, with the three parties given until 2036 to reach consensus before the pact lapses.

The negotiations ahead will generate a series of alarming headlines that weigh on consumer sentiment, business confidence—and both currencies. But a major realignment in North American trade relations remains unlikely****: as the president has discovered, his allies in Congress and the business community are well aware they have much to lose, and the population is growing increasingly wary of measures that could lift American prices.

*Both sides claim they’re still observing a ceasefire.

**Signalling is a central part of any central banker's toolkit, used to manage inflation expectations before they become self-fulfilling.

***“Excess supply” is the Bank of Canada's term for “the economy is bad, which is good”. You, the reader and participant in the economy, may get different mileage.

****Not impossible, just unlikely.

Market Overview

Data as of 7:15 AM EDT

Notes: DXY: Dollar index, DMA: Daily Moving Average, Pivot points are calculated on a one-month basis, 3-month and 10-year spreads are against USD, Implied V.: implied at-the-money option volatility

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