Market Brief: Dollar keeps steamrolling forward

The trade-weighted dollar is holding near a sixteen-month high, Treasury yields are slipping, and US equity futures are rebounding after a steep technology-led selloff earlier in the week.

Oil prices are slipping as markets brace for the release of millions of barrels in pent-up supply. Physical flows through the Strait of Hormuz are beginning to resume as tankers get underway and a US waiver on Iranian exports takes effect, pushing prices on floating cargoes lower. Front-month Brent futures are trading near $75 a barrel and West Texas Intermediate around $71—roughly 25% above pre-war levels, but down sharply from their highs. If sustained, the ongoing decline in global energy prices should translate into a weakening in the inflation impulse that has forced most major central banks to turn more hawkish, and might unleash another round of adjustments in policy expectations.

Foreign exchange markets are being buffeted by a number of crosscurrents:

The British pound is down almost 2% against the dollar this month, but is outperforming the euro as political uncertainties dissipate. With his most prominent potential challengers bowing out of the race, former Manchester mayor Andy Burnham looks set to succeed Keir Starmer as prime minister in the coming months, and is increasingly seen appointing Wes Streeting—a relatively centrist, pro-business figure—as chancellor. Sterling is holding near a 10-month high against its continental counterpart.

The euro is trading dangerously close to technical support levels as investors turn more sceptical on the likelihood of further rate increases from the European Central Bank this year. A measure of private-sector activity published by S&P Global yesterday showed downward momentum slowing and business confidence improving across the currency bloc earlier this month, but also showed cost pressures subsiding, suggesting that ongoing declines in global crude and natural gas prices could translate into a weaker inflation impulse in the months ahead. Traders are now watching the 1.1340 threshold*, with a breakthrough carrying the potential to open up a move into the low 1.10’s.

With the Bank of Canada** seen keeping rates on hold for many months yet, the Canadian dollar remains on the defensive—but appears to be finding a floor, holding on the weaker side of several key technical levels. The currency's vulnerabilities are well understood: soft growth, non-existent demand-led inflation, wide rate differentials, persistent trade uncertainties, and a post-war deterioration in commodity terms of trade. We don’t see upcoming USMCA negotiations offering any catalyst for a positive reversal, but the loonie looks undervalued at current levels, and downward momentum is clearly fading, suggesting that the risk-reward bias may be shifting in its favour.

Mexico’s peso is retreating in line with its global counterparts even after the economy expanded at its fastest rate in five years in April, beating market expectations. According to the national statistics agency, activity grew 1.2% in April from the prior month, accelerating from 0.6% in March on an improvement in the construction and manufacturing industries. Banxico is expected to stay on hold and keep its forward guidance cautious in tomorrow’s decision after signalling that last month’s move marked the final cut in the current cycle, and traders think the peso’s carry premium could continue eroding as US rate expectations move up***.

Pressure on the yen is being sustained as rate differentials widen, yet traders remain wary of building short positions after the latest round of verbal warnings from Tokyo. Minutes from the Bank of Japan's June meeting—at which it raised rates to a 31-year high—last night showed some officials turning more hawkish in the face of mounting inflation risks. But investors think those risks are now receding alongside oil prices, and the rate gap with the US is widening again, pulling the currency back toward the levels that have historically triggered intervention.

But the dollar’s advance remains the main story in global currency markets.

Last week's hawkish turn from Federal Reserve chair Kevin Warsh and his colleagues on the rate-setting committee tilted expected policy rate differentials more sharply in the dollar's favour while helping restore confidence in the currency's longer-term haven credentials. Traders now expect the world's most powerful central bank to deliver 37 basis points of tightening by year-end, reinforcing the dollar's short-dated yield premium over its advanced-economy counterparts while also weighing on inflation expectations, helping to keep the long end anchored.

The US economy keeps beating expectations. With a wave of tax refunds supporting spending and the artificial intelligence boom boosting activity throughout the private sector, economic surprise indices have turned higher, reinforcing the case for firmer policy and a stronger currency into the second half of the year.

We nonetheless think bullishness on the dollar is getting overdone. The currency screens as richly valued on most technical and fair-value measures, making it vulnerable to a shift in narrative. Positioning has swung decisively long, leaving the greenback exposed to a sharp unwind should the data flow disappoint, Fed officials articulate more dovish views, or the artificial-intelligence trade underpinning risk appetite begin to wobble.

*A Fibonacci retracement level, but you probably don't need to know that some currency traders put faith in ideas that resemble astrology.

**Apropos of nothing, Governor Tiff Macklem delivered an excellent speech in Paris yesterday, hammering many of the themes you've seen discussed in these notes, as well as in presentations. As an efficient encapsulation of the contradictions embedded in today's global economy and financial system, you could do worse.

***If I'm right in thinking that US rate expectations are getting overdone, the peso's carry return profile could improve once again, reigniting its upward trajectory, at least temporarily.

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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