Market Brief: Investors Keep Powder Dry In Run-Up to Fed Meeting

The dollar is giving back yesterday’s gains, Treasury yields are holding steady, and North American equity markets are moving sideways as investors await news on the US role in the Israel-Iran conflict — and brace for this afternoon’s Federal Reserve decision. Oil prices leapt higher during yesterday's session after US president Donald Trump called for Iran's "unconditional surrender" in a social media post, suggesting that American forces could soon join the fray, and raising the risk of a wider escalation in the war, but are now subsiding as traders monitor the newswires.

The world’s most powerful central bank is widely expected to avoid rocking the boat at this afternoon’s meeting. Policymakers have clearly telegraphed a desire to stay on the sidelines until they can more accurately assess how well the economy is handling the Trump administration’s tariff increases, and have prepared markets for an extended period on hold. Language used in the statement and in Chair Powell’s post-decision press conference is likely to remain steadfastly neutral.

Instead, market turbulence could be generated by the Statement of Economic Projections, which will offer insight into how officials perceive evolving risks within the economy. Projections for gross domestic growth, unemployment, and inflation are likely to shift in a less favourable direction — growth forecasts are expected to be revised downward from March’s outlook, while estimates for the unemployment rate and inflation may be nudged higher. The US economy has consistently underperformed consensus expectations in recent months — particularly when compared with the euro area.

The "dot plot" outlining the projected path for the Fed Funds rate is unlikely to change significantly; the median forecast is still expected to reflect two rate cuts this year and next. However, in light of persistent concerns over a potential de-anchoring of inflation expectations, officials may opt to indicate just one rate cut for this year, meaning that risks to the dollar appear modestly tilted to the upside.

We think recent oil price increases are unlikely to play a major role in destabilising the US economy. As a share of consumption, energy costs have fallen dramatically over recent decades, meaning that most households are somewhat insulated against a modest rise in global benchmarks.

After a decade-long shale oil boom, the US also tends to see a boost to its terms of trade when crude benchmarks climb, flipping a historically-negative correlation between oil prices and the US dollar. Yesterday’s trading dynamics illustrate this point — as market speculation built around the prospect of a US strike on Iran and oil prices climbed, the dollar also gained sharply — and we don’t see this changing on any reasonable trading horizon.

Across the pond, inflation in the UK remained uncomfortably high but a measure of underlying services costs slipped last month, complicating the Bank of England’s easing plans. According to an update published by the Office for National Statistics, headline prices climbed 3.4 percent in the year to May as food and goods costs accelerated slightly, setting the stage for a more robust increase in June — when a war-driven spike in oil benchmarks is likely to make itself felt. The “core” services measure (which excludes some travel and education items) decelerated however — from 5.6 percent on a year-over-year basis in April to a flat 5 percent — potentially giving policymakers some room for manoeuvre as they consider cutting rates again in the early autumn. Markets now have the next move fully priced in for October, and the pound is retreating from its overnight highs.

Here in Canada, the loonie is struggling to capitalise on gains in energy prices. A still-soft domestic growth backdrop — characterised by negative business sentiment, feeble investment, a depressed housing market, and rising unemployment — is adding to the Bank of Canada’s dovishness to keep rate differentials under pressure. A record of the central bank’s last meeting, released yesterday, showed policymakers expressing a willingness to “look through” tariff-driven price increases as they considered cutting rates further. On the face of it, a persistent gap between US rates and their Canadian equivalents suggests that the loonie is currently overvalued.

However, although the difference between Canadian and US unemployment rates has widened in recent months, this has merely brought the gap* into closer alignment with the exchange rate. We suspect that some narrowing is ahead however. Under-the-hood details are pointing to a softening in US labour markets and an incremental rise in joblessness over the summer, potentially justifying a more dovish stance from the Fed, and a narrowing in cross-border rate differentials. The exchange rate could remain rangebound for longer, frustrating Canadian dollar bulls and bears in equal measure.

*Thank you to BMO's Doug Porter for pointing out this relationship many years ago

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