Market Brief: ECB Holds, Signals Patience on Rate Cuts

Global currency markets are stabilising and the euro remains essentially unmoved after the European Central Bank left its main policy settings unchanged while avoiding telegraphing a move in September. In a mostly unmodified statement, officials said “domestic price pressures are still high, services inflation is elevated and headline inflation is likely to remain above target well into next year,” while acknowledging that most measures of underlying price pressures “were either stable or edged down in June”. Potentially foreshadowing comments from President Lagarde during the press conference, policymakers inserted a sentence warning market participants against inferring signals about the future direction of policy, saying “The Governing Council is not pre-committing to a particular rate path”.

Despite the hawkish undertones, most observers expect two more rate cuts this year, with early-September’s softer wage data seen clearing the way for a second move. The euro area economy is showing signs of slowing momentum after a brief acceleration earlier in the year, and data out this week showed the central bank’s policy stance continuing to exert downward pressure on business investment and overall credit growth. Bund yields remain soft, and other European bond markets have seen rates retreat from levels reached during the French election scare - a dynamic which has helped offset declines in US yields since last week’s inflation print.

The British pound is holding near a one-year high after wage growth numbers declined in line with expectations, keeping the Bank of England on hold through the summer. Updated data from the Office for National Statistics showed ex-bonus average weekly earnings rising 5.7 percent in the three months ended in May, down from 5.9 percent previously, exactly meeting consensus. Traders are pinning sub-30-percent odds on a cut at the Bank’s August meeting, down sharply from a few weeks ago on still-stubborn services inflation and a series of cautionary appearances from Chief Economist Huw Pill.

Japan’s yen remains stronger after spending the last week reenacting the plot from “The Fast and the Furious: Tokyo Drift*,” gaining more than 4 percent against the dollar in short order. Last week’s softer-than-anticipated US inflation report did a lot of the heavy lifting, but currency intervention from Japanese authorities and combative words from Donald Trump have added momentum to the move. We’re sceptical on the potential for further gains: next week’s Bank of Japan meeting is unlikely to result in a sharp narrowing in rate differentials, appetite for using the yen in funding carry trades is liable to return, and speculative short positioning - which reached the second highest level ever recorded in early July - will probably show signs of having retreated when updated numbers are released over the coming two weeks. Short squeezes can only carry a currency so far.

A series of Fed officials made dovish noises yesterday, suggesting that the consensus has shifted toward favouring a September rate cut. New York President John Williams - arguably the intellectual heavyweight on the central bank’s rate-setting committee - and Governor Christopher Waller - known for foreshadowing future changes in policy - both suggested that easing would soon become appropriate if inflation remains moribund and labour markets continue to soften. In an interview with the Wall Street Journal, Williams said that the last three inflation reports were “getting us closer to the disinflationary trend that we’re looking for”. Speaking to an audience in Kansas City, Waller said “As of today, I see there is more upside risk to unemployment than we have seen for a long time … While I don’t believe we have reached our final destination, I do believe we are getting closer to the time when a cut in the policy rate is warranted”.

Although signs of weakness in the real economy have been limited, policy remains fundamentally restrictive. Based on June’s consumer price index and its producer price equivalent, the Fed’s preferred inflation measure - the core personal consumption expenditures index - looks likely to increase by roughly 0.17 percent in June when new data is released next Friday, maintaining a year-over-year pace of around 2.6 percent. This is well below the effective federal funds rate, which is currently sitting at 5.33 percent, and far below the San Francisco Fed’s “proxy” rate, which uses public and private borrowing rates and spreads to measure the impact of forward guidance, balance sheet changes, and other aspects of the broader monetary policy stance. A quick glance at the historical record shows that keeping policy at these levels for too long - waiting for the “whites of their eyes” to show in economic data - can lead to a sharp downturn, and we therefore expect a more explicit - but still conditional - easing bias to emerge on July 31 when Chair Powell next faces the news cameras.

Today’s agenda looks relatively quiet. Initial US jobless claims, out a few moments ago, rose to 243,000 in the week ended July 13, up from the previous week’s 222,000, and continuing claims rose by another 20,000, climbing on a four-week average basis as labour market conditions continued to cool. And the Fedspeak will continue until morale improves, with Chicago’s Austan Goolsbee, Dallas’ Lorie Logan, San Francisco’s Mary Daly, and Governor Michelle Bowman making appearances throughout the day.

Tomorrow’s Canadian retail sales number isn’t likely to swing the chances of a rate cut at next week’s Bank of Canada meeting in any material way. After the country’s unemployment rate shot up to 6.4 percent and Tuesday’s June inflation report undershot expectations, markets are putting 93 percent odds on a July cut, and - after previously looking for a move in September - we’re inclined to agree.

But another weak spending print could serve to highlight the deeper malaise at the heart of the Canadian economy. Statistics Canada is expected to confirm its advance estimate for a -0.6 percent decline in receipts, which will mean that inflation-adjusted sales have fallen on a per-capita basis since the central bank began raising rates in 2022. There are many factors behind this, but we think weakness in the real estate market - which over the last two decades had become the country’s dominant economic engine, biggest source of wealth creation, and the underpinning for a spectacular increase in household leverage - is the key driver. Prices have now come down by more in real terms than in any other Group of Seven economy since the global tightening cycle began, and there’s little evidence to suggest that strong demographics and improving investor sentiment can overcome higher financing costs in driving a sustained rebound. Credit-fuelled household consumption - which had become deeply dependent on rising home values - is likely to remain restrained for a considerable period of time.

To modify the old saw, there are two kinds of foreign exchange strategist: Those who don’t know where currencies are headed, and those who don’t know that they don’t know. But it does seem likely that upside opportunities for the Canadian dollar will remain capped until the economy rebalances in a more sustainable direction - and that could take years.

*Okay, okay, I admit that I haven’t watched it - but it seems safe to assume that it involves cars moving at a fast and furious pace while Vin Diesel does his best to impersonate the sound of a diesel engine.

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