Market Brief: Dollar climbs as rate differentials grow more supportive

The dollar is edging toward an 18-month high as the Federal Reserve maintains its tightening bias, while higher energy prices and rising yields weigh on other major currencies. The euro, British pound, Canadian dollar, and Mexican peso are all trading near the bottom of their recent ranges, reflecting a fairly consistent move in rate differentials relative to the dollar.

Yesterday’s minutes from the Fed's September meeting confirmed what markets already believed. Participants unanimously agreed that disinflation was making too little progress and that borrowing costs should climb as geopolitics and the artificial-intelligence buildout add to upside price risks. Most felt that another move would be appropriate by year end, helping “support a timelier return of inflation” to target. Since the meeting, softer inflation and labour-market data, alongside cautious guidance from Vice Chair Jefferson and New York Fed President Williams, have led investors to scale back near-term tightening expectations, with futures now putting roughly 20% odds on a hike later this month, down from more than 70% early last week.

Policymakers did, however, offer differing rationales for raising rates. Some framed tightening as a means of curbing demand-driven inflation already embedded in the outlook, while others saw it as a form of precautionary insurance against a rise in inflation expectations after nearly six years of above-target price growth. That lends added significance to yesterday's survey of consumer expectations from the New York Fed, which showed the median household expectation for inflation one year ahead climbing to 3.9% in September from 3.6% the prior month, and the share expecting inflation to exceed 4%—reaching its highest since early 2023. There’s little evidence to suggest financial markets are growing more concerned—the measures typically watched by investors have remained tame—but if Fed officials are focused on consumers, it is reasonable to think that more tightening could be in the offing.

Oil prices are up almost 4% from yesterday as traders prepare for weather-related supply disruptions, scale back expectations for reserve releases, and brace for an escalation in the US-Iran war. Hurricane Isaias is bearing down on the Gulf of Mexico, forcing producers to shut an estimated quarter of the region's oil-producing facilities. Hopes for a significant near-term supply boost are crumbling after the International Energy Agency clarified that while its members have agreed to release 100mn barrels of crude and refined products over the next four months, those barrels will come from the 400mn-barrel release agreed in March. And confidence in an eventual breakthrough in the Strait of Hormuz is fading as Iran steps up the tempo of its attacks on shipping and Axios reports that the US is preparing to resume major combat operations.

The euro is holding near a 17-month low as the spread between French and German ten-year yields, a measure of sovereign risk, widens once again. As outlined in recent missives, we don’t see this as a repeat of the turmoil of the early 2010s: peripheral countries have put their finances on firmer footings, the bloc has a far more credible crisis-fighting framework in place, and fragmentation concerns have receded into the background. But the European Central Bank's first line of defence is to sound a little less hawkish, and we think there is still room for markets to scale back expectations for the number of rate hikes over the year ahead. Interest differentials are unlikely to offer the euro much support until that process has run its course.

Economic Calendar