Market Brief: Dollar Selloff Resumes Ahead of Jackson Hole

A selloff in the dollar is intensifying this morning as investors grow more confident in a clear easing signal from Chair Jerome Powell at the Federal Reserve’s Jackson Hole economic symposium later this week. The greenback is holding near a three-week low, almost erasing its year-to-date gains, Treasury yields are ratcheting lower, equity indices are climbing, and volatility assumptions are coming down as a tide of optimism washes over global markets.

The euro is trading near its highest levels this year as investors turn more cautious on the European Central Bank’s rate cutting path. Measures of underlying inflation slowed only incrementally in July, and Indeed’s wage-growth tracker showed pay rising at a steady year-over-year pace, suggesting that policymakers might not have persuasive evidence in hand to justify easing at their September meeting. We note that the euro area current account surplus climbed to a record 50.5 billion euro in June, suggesting that the bloc is back to exporting vast amounts of capital to the rest of the world - something that has historically generated short-term currency strength while also planting the seeds for an eventual misallocation of capital in global markets.

The British pound is also steamrolling upward, propelled by a narrowing in cross-Atlantic rate differentials. The Bank of England is seen cutting rates more gradually than its counterparts, with incoming data suggesting that the disinflation process is likely to slow in coming months. Sterling has emerged as the strongest Group of Ten currency this year, but has risen in nine of the last ten trading sessions, suggesting that a period of consolidation is growing increasingly likely*.

Friday’s appearance from Federal Reserve Chair Powell looks priced for perfection. Money markets have 93 basis points in rate cuts priced in by year end, implying at least one unusually-large 50 basis-point move in the autumn months. If Powell sounds insufficiently dovish, providing a more balanced perspective on the risks facing the economy - or simply conveying a lack of urgency in getting rates back down to neutral - traders could pull back on expectations for a front-loaded easing cycle, helping the dollar regain altitude.

The Canadian dollar is grinding higher as its “risk proxy” characteristics power outperformance against the greenback, and could add to its gains in the coming days if broader market narratives don’t shift in an adverse manner. Falling global interest rates, subsiding volatility, and rising asset prices are all favourable for Canadian financial markets, which are inextricably tied to developments in one of the world’s most overleveraged household sectors.

Any outsized market reaction to this morning’s July consumer price update should be regarded with suspicion**. With the labour market and wider economy exhibiting clear signs of slack, policymakers appear broadly comfortable with the pace at which inflation is coming down - and the likelihood of a reacceleration looks very low. The economic consensus has shifted in a more favourable direction in recent months - odds on a recession have tumbled in line with the US - but this is heavily dependent on a central bank that remains willing to ease policy on a preemptive basis. Markets see at least two - perhaps three - rate cuts coming through the remainder of the year, and we think employment, consumer spending, and growth data will play a bigger role than inflation in setting expectations on the margins.

*This amounts to a psychological fallacy - there’s no fundamental reason for a reversal in momentum after a period of outsized performance - but it is a psychological fallacy shared among certain market participants, so it tends to influence price action. As Charlie Munger once put it:

“A teacher asks a class a question: There are ten sheep in a pen. One jumps out, how many are left?

Everyone except one boy said nine are left. The boy said none are left.

The teacher said, “You don’t understand arithmetic.”

He said: “You don’t understand sheep.”

**I won’t clog your inbox with a reaction note after the release unless it contains something surprising.

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