Market Brief: Dollar Sends Out-of-Office Autoreply 

The almighty greenback is making a lacklustre attempt at climbing off the mat after suffering the worst selloff in a year during Friday’s session, with rising geopolitical tensions doing little to reverse its losses. On a trade-weighted basis, the dollar is up incrementally this morning, but has fallen roughly 3 percent this month, pacing declines in Treasury yields even after Israeli airstrikes on Hezbollah targets in Lebanon generated a mild safe haven bid over the weekend. Oil prices are modestly higher, equity futures are seeing cautious inflows, and the pound, euro, and yen are turning in mixed performances amid holiday-thinned liquidity conditions.

Last week brought evidence of a shift in the Federal Reserve’s reaction function. Minutes taken during the central bank’s July meeting showed officials growing more confident in the downward path of inflation, and far more concerned about weakness in employment. In Friday’s appearance at the Jackson Hole economic symposium, Jerome Powell was less-than-subtle, saying “The cooling in labour market conditions is unmistakable,” noting that “policymakers do “not seek or welcome further cooling in labour market conditions”, and pledging to “do everything we can to support a strong labour market as we make further progress toward price stability”.

Powell clearly set the stage for policy easing, and avoided delivering the “gradualist” message that might have upset market expectations. Although he warned “the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks,” he also noted that prevailing policy settings are “restrictive” - a view partially ratified by last week’s benchmark revisions to non-farm payrolls numbers, which showed labour markets slowing far earlier than previously believed - and said “the current level of our policy rate gives us ample room to respond to any risks we may face,” suggesting that central bankers could respond decisively to signs of incipient economic weakness.

Markets expect the Fed to deliver a ‘shock and awe’ rate-cutting campaign against an economic backdrop distinctly lacking in either shock or awe. With the US economy seen achieving a soft landing while the Fed follows canonical policy guidelines - like the Taylor Rule* in cutting aggressively, expectations for year-end rates across the major economies have converged in the last month, reducing the dollar’s appeal from a yield perspective. Thus far, this has come without the offsetting force - the flight to safety - that typically ensues once the US economy begins slowing in earnest, but we can’t discount the possibility in the months ahead. As long as the Fed is cutting because it can, the dollar should depreciate in a gradual manner, but as soon as the Fed begins cutting because it has to, the dollar will rebound.

After speculators spent much of the last two months building a record short position against it**, the Canadian dollar is outperforming. Rate differentials have narrowed in the currency’s favour as the Fed has moved closer to beginning an aggressive easing campaign. Global interest rates have come down, reducing stress on the country’s highly-leveraged households and businesses. And the crowdedness of the trade is likely exacerbating upside moves, with many leveraged players forced to buy the currency back as they are squeezed out of short bets.

Hedgers are facing a particularly challenging trading backdrop.

This week should see typical choppy late-August price dynamics in weak-conviction and low-volume markets, but today’s durable goods number, tomorrow’s Conference Board consumer confidence update, Friday’s personal consumption expenditures print, and Canada’s second-quarter gross domestic product report will provide more than enough material for volatility - and the impact of all of that data could pale in comparison with Wednesday’s Nvidia earnings release.

But the following week - in which the Institute for Supply Management’s August update and the latest non-farm payrolls report will land - is highly likely to see several major shifts in positioning as market participants adjust expectations for a half-percentage move at one of the Fed’s autumn meetings. Extreme perceptions surrounding Jerome Powell’s data dependence could translate into violent moves if consumer spending remains strong or jobs numbers are more robust than currently anticipated. Volatility is very likely.

*The Taylor Rule says that if you date Taylor Swift, you will eventually feature in a diss track heard by millions. I kid, I kid. Here’s a more accurate description: Principles for the Conduct of Monetary Policy

**As suggested in previous notes, speculative positioning tends to work most effectively as a contrarian indicator - when punters are crowded into a trade in sufficient numbers, the narrative they’re responding to is almost always fully priced in. Put more succinctly: fools rush in.

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