Market Brief: Dollar Retraces Last Week's Rebound on Easing Expectations

The case for an emergency-style half percentage-point rate cut at the Federal Reserve’s September meeting took a series of blows last week, helping boost Treasury yields and halt the dollar’s long slump. Inflation slowed in July, but exhibited no evidence of collapsing consumer demand. Initial applications for unemployment benefits fell for a second consecutive week, suggesting that labour markets were not suffering the violent reversal feared only a few weeks earlier. And recession worries eased as headline retail sales accelerated by the most since last January.

Jerome Powell is widely expected to telegraph a September rate cut in Friday’s appearance at the Jackson Hole Economic Policy Symposium. Yields are softer and the dollar is retreating to start the week as traders bet the Fed chair will acknowledge an ongoing shift in the balance of risks facing the US economy, suggesting that restrictive policy settings are no longer appropriate, and opening the door to an imminent easing decision. The euro, pound, and Chinese yuan are all inching higher ahead of the North American equity market open.

But the scale of the cut and the pace of subsequent moves will remain up for debate. The title of the event - “Reassessing the Effectiveness and Transmission of Monetary Policy” - hints at the extent to which the economy has surprised observers, staying resilient in the face of the fastest tightening cycle in decades, and surviving repeated recession scares. Chair Powell is unlikely to put the central bank on a more aggressive easing trajectory without sustained evidence of a rollover in growth and employment, and investors may find themselves disappointed with the substance of his remarks, and odds on a jumbo-sized cut could decline further from today’s levels.

The Japanese yen is climbing against the dollar as traders brace for hawkish messaging from Bank of Japan Governor Kazuo Ueda later in the week. Ueda was summoned to testify in front of the Diet after July’s rate-hike decision triggered the biggest stock market crash since 1987 and led to a disorderly unwind in the yen-funded carry trade, but conditions have calmed considerably in the intervening weeks, and the rationale for a gradual tightening in monetary policy settings remains strong.

Carry trade flows will eventually resume, but we think Ueda will stay the rhetorical course for now, subtly suggesting that more rate hikes are likely to come in the year ahead as long as global financial conditions don’t tighten meaningfully, meaning that the rate differentials that have depressed the yen for the better part of three decades should continue to narrow. In a worrisome sign*, speculators agree - shorts against the currency collapsed and gross long bets neared the 2016 peak in recent weeks, tilting positioning back into net long territory for the first time since 2021.

In theory, tomorrow’s July Canadian inflation report could have market-moving implications for longer-term rate settings, but we think policymakers have already pivoted toward more fundamental concerns. The all-items price index and an average of the Bank of Canada’s preferred core measures are both seen slowing from the pace recorded in June - 2.7 and 2.9 percent, respectively - and shelter-excluded aggregates should hold below the central bank’s 2-percent target. With growth lagging, employment conditions worsening, and the all-important housing market failing to generate a meaningful recovery, the case for more easing is likely to remain intact, making a rate cut on September 4 all but certain. Three moves are priced into markets by the end of December, implying a cut at each meeting this year.

Today’s session looks extraordinarily quiet from an economic data perspective, with the Democratic national convention looming as the only first-tier event on the calendar. Despite the sell-side’s best efforts, no ‘Kamala trade’ has emerged in markets yet: a careful readthrough of last week’s speech suggests that her claims of “price gouging” in the corporate sector are unlikely to result in a Nixon-like attempt to fix prices, and other communications have been light on policy details, especially as far as currency-relevant trade relationships are concerned. This is unlikely to change in the hours ahead.

The ‘Trump trade’ could make a modest recovery, however - particularly if demonstrations against the administration’s Middle East policy manage to disrupt the event and cast the party in an unfavourable light. There are clear parallels with the 1968 Democratic convention - which saw anti-Vietnam War protests bolstering Republicans law-and-order messaging and leading to a solid drubbing at the polls - so a tilt in market odds toward the former president’s party remains possible.

*Just like currency strategists, speculators are almost always wrong, meaning that big shifts in positioning often serve as good contrarian indicators.

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