Market Brief: Dollar Reverses Higher as Economy Refuses to Slow

The dollar looks set to close out August on a slightly stronger footing as signs of economic resilience help bolster the case for a more cautious rate-cutting cycle from the Federal Reserve. Treasury yields are ratcheting incrementally higher, stock markets are advancing - led by the biggest technology names - and most major currencies are trading sideways ahead of the North American open.

Yesterday’s data releases showed the US economy defying the doom-and-gloom crowd. Real gross domestic product growth was revised upward for the second quarter from 2.8 percent to 3.0 percent, accelerating sharply from the first quarter’s 1.4 percent expansion. Real final sales to private domestic purchasers - considered a more accurate measure of underlying demand - climbed from 2.6 percent to 2.9 percent. Retail inventories jumped 0.8 percent month-over-month in July, topping forecasts. And the number of initial unemployment claims fell to 231,000 in the week ended August 24, further lowering the four-week moving average, and reducing the likelihood that a ‘hard landing’ is underway in job markets.

Today’s numbers might fail to move the needle on perceptions. With key inputs already incorporated, the core personal consumption expenditures index - the Fed’s preferred inflation indicator - is seen rising 2.7 percent year-over-year in July, marking a slight acceleration over the previous month. Economists think inflation-adjusted household spending could jump 0.3 percent, reflecting continued growth in real incomes.

But markets remain convinced that the Fed will deliver at least four rate cuts over the next three meetings, and interest differentials have narrowed against the dollar across the curve. Among the major currencies included in the DXY dollar index*, British pound-denominated ten-year government bonds now yield more than their US counterparts, and the dollar’s rate premium over the euro, yen, loonie, Stokkie, and Swissie has eroded substantially in the last month.

We’re not sure this market structure will survive contact with next week’s data. If next Friday’s August non-farm payrolls report fails to demonstrate further cooling in labour markets, the perceived need for an emergency-sized half-percentage-point cut at the Fed’s September and November meetings could fall, putting upward pressure on short-term yields and the dollar. Volatility in currency markets could prove hazardous to the health of the unhedged.

The euro is back on the defensive after bloc-wide inflation dropped to its lowest levels since early 2021, bolstering support for another rate cut from the European Central Bank. Data released this morning showed headline consumer prices rising 2.2 percent in the year to August as energy costs fell, and the core measure subsided to 2.8 percent from 2.9 percent in the prior month, giving policymakers room to respond to declining growth and wage pressures. Overnight index swap pricing suggests that the central bank will ease twice by year end, but odds on a third move are steadily creeping higher.

Mexico’s peso continues to barf over the side of the rollercoaster, snapping a little more than 1 percent higher this morning, but remaining almost 3 percent weaker on the week. The exchange rate has come under sustained selling pressure for days as the government’s efforts to expose the judicial system to political exigencies have gained steam, and downward growth revisions embedded in the Banxico’s quarterly report on Wednesday have done little to alleviate the gloom. The currency’s leverage to the US economic cycle implies modest short-term gains as incoming data proves more resilient than anticipated, but rate differentials also look poised to narrow as the Mexican growth engine slows and the central bank makes increasingly-dovish noises.

The Canadian economy may also show signs of stabilisation in this morning’s data update. Although output likely expanded at a lacklustre pace in the second quarter, with consensus estimates pointing to a 1.4-percent annualised growth rate in the three months ended June, the advance estimate for July could reflect a slight improvement in personal incomes and consumer sentiment, setting the stage for a modest rebound in the early third quarter.

To be clear, no one is suggesting that the Canadian economy is about to blow the doors off. Growth remains weak on a real per-capita basis, and signs of a rebalancing toward a more sustainable, higher-productivity growth model remain almost non-existent. But the recent easing in financial conditions will provide relief to the country’s overleveraged private sector, and thus far, there’s been very little evidence of a serious retrenchment in consumer demand.

Bets against the Canadian dollar look likely to retrace further from the extremes reached a few weeks ago. With two rate cuts already under its belt and effective policy rates sitting almost 100 basis points below their US counterparts, traders don’t expect the Bank of Canada to outpace the Fed in delivering more easing over the next year. Macklem & Co. are seen cutting rates six times in the next 12 months, while Powell & Friends are priced for eight moves. Data out later today might show the net speculative short on the loonie almost halving from early-August’s historic levels in the week ended Tuesday, and we think more trimming will come in next week’s numbers.

But the Canadian dollar’s ‘risk proxy’ status looks likely to remain intact. Canada’s second-quarter balance of payments data - released yesterday - showed the country’s net basic balance, the broadest measure of capital flows, remaining negative for the currency, amounting to roughly -3.5 percent of gross domestic product, if our output estimates are correct. The current account remained firmly in deficit territory for an eighth consecutive quarter, net direct investment hit its highest levels since 2007, and Canadian governments and corporates sold $67.3 billion in bonds to foreign investors, reflecting a heavy dependence on external funding. If global economic and market conditions turn more turbulent in coming months, the loonie could find itself on the firing line yet again.

*Much to our chagrin, the most-followed measure of the dollar’s strength is not a trade-weighted basket, and is really more reflective of 1973’s currency markets than today’s. But we try not to tilt at windmills here - they keep getting bigger and stronger.

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