Market Brief: Fragile Calm Returns

Fear levels are subsiding across financial markets after a week that shattered the typical August calm. The safe-haven yen and Swiss franc are tumbling against a recovering dollar, Treasury yields are edging upward, equity futures are pushing higher ahead of the North American open, and measures of financial stress are reverting toward levels that prevailed ahead of the July non-farm payrolls report.

Last week’s moves are now seen as an overreaction. After the Institute for Supply Management’s services index rebounded and weather-related distortions were removed in last week’s initial claims data, the consensus has shifted toward expecting a continued deceleration in the US economy - not a recession. Stock markets have largely recovered, and the number of rate cuts expected from the Federal Reserve by year end has fallen to four, down from more than five at the peak of the market selloff. With officials downplaying the need for an urgent policy pivot, odds on an inter-meeting move have dropped back to near-zero levels, and the likelihood of a jumbo-sized move in September has corrected sharply lower.

The Canadian dollar is trading on a modestly softer footing after Friday’s employment data kept the Bank of Canada on track toward delivering another rate cut at its meeting on September 4. The country’s labour market remained relatively weak for a second month in June, with the public sector generating the bulk of the full-time job gains, the fastest wage gains, and—very likely—a substantial share of the hours worked across the economy. The employment rate fell 0.2 percent, and the participation rate declined to 65 percent, resetting back to levels last recorded after a serious downturn in the nineties. Overnight index swap markets are pricing six rate cuts from the Bank between now and July next year, amounting to roughly one per quarter.

Both the pound and euro are clinging to last week’s levels, with the outlook looking modestly brighter for sterling ahead of a week in which a series of data releases could reinforce constructive views on the economy. The overreach in speculative positioning that prevailed late last month has been almost fully unwound, the country’s relationship with the euro area appears to be improving, and labour, inflation, and growth numbers in the coming days should help support expectations for a more cautious approach to easing from British central bankers in the months ahead. Traders think the Bank of England will cut rates four times by the middle of next year, with the European Central Bank moving at least five times.

Yen-related carry trade vulnerabilities have been reduced. After the biggest four-week unwind in listed yen shorts since the run-up to the global financial crisis in 2007, many of the traders most exposed to margin calls have been wiped out, and major banks with large speculative books are reporting diminished risk levels. The Bank of Japan is making reassuring noises about tightening more cautiously in the future, and the exchange rate is declining as still-wide yield differentials hamper upside.

But volatility expectations have unquestionably reset higher, and traders are still in a trigger-happy mood. After retracing from a high near 65, the VIX index—Wall Street’s ‘fear gauge’—is holding above the 20 threshold typically indicative of moderate stress levels, with options markets bracing for renewed turbulence around this week’s inflation data and Jerome Powell’s appearance at the Jackson Hole Economic Symposium next Thursday.

July’s price data will drive a renewed calibration in monetary policy expectations. Tomorrow’s producer price index is seen rising at a similar 0.2-percent pace as in June, with the factors that feed into the Fed’s preferred inflation measure—the core personal consumption expenditures deflator—exhibiting signs of continued moderation. If Wednesday’s core consumer price index matches consensus in rising 0.2 percent on a month-over-month basis—a pace consistent with a gradual convergence toward the Fed’s target—markets might further reduce odds on an inter-meeting rate cut, and the dollar should gain altitude. In contrast, a sub 0.1-percent print would reawaken ‘hard landing’ fears, pulling yields and the dollar lower once again. An acceleration to 0.3 percent or higher looks decidedly unlikely, but could demolish market consensus, bolstering yields and the greenback.

With liquidity levels remaining low, geopolitical risks simmering in the background, and perceptions on the state of the US economy still in flux, it’s too soon to sound the ‘all-clear’ in currency markets. If—as we suspect—markets are undergoing a regime shift in which the risk outlook turns more asymmetric, buyers will become less willing to step in when shocks hit in the coming weeks, meaning that risk-sensitive pairs could be exposed to renewed turbulence. We think volatility expectations will remain elevated well into the autumn months.

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