Market Brief: Iran headlines dominate currency market price action

Treasury yields and the dollar are retreating from yesterday's highs after Hezbollah and Israel agreed to temporarily halt cross-border fighting, giving Iranian officials cause to return to the bargaining table. Oil prices had posted their sharpest one-day surge in a month after Tehran said it was abandoning talks amid an intensifying Israeli assault on Lebanon, reviving supply fears that had been dormant for weeks. Both Brent and West Texas Intermediate are down roughly 1.3% this morning, ten-year Treasury yields have eased back to 4.42%, and the trade-weighted dollar is edging lower as traders unwind the defensive positioning built up during the flare-up.

American factory activity expanded for a fifth consecutive month in May and price pressures stayed stubbornly elevated, reinforcing market bets on at least one rate hike from the Federal Reserve by year end. The Institute for Supply Management’s purchasing managers’ index hit 54, well above the 50 threshold separating expansion from contraction and its highest reading since May 2022, as domestic and foreign order books improved and inventories fell. A measure of input prices remained above 80 for a second month, and comments from survey respondents were overwhelmingly focused on high fuel costs, tariffs and shortages of industrial metals and chips.

The dollar could gain momentum through the week if US-Iran negotiations remain inconclusive and Friday's non-farm payrolls report confirms continued resilience in the world's largest economy. Against a backdrop of high and rising oil prices, a gain of around 85,000 jobs, a steady unemployment rate and firm wage growth should be enough to keep monetary tightening expectations anchored at current levels—and with them, the dollar's yield premium.

The euro is trading on a firmer footing after inflation accelerated across the common currency area last month, bolstering expectations for further tightening ahead of next week's European Central Bank meeting. Eurostat's headline price index climbed 3.2% in the year to May, up from 3.0% in April, driven by a 10.9% surge in energy costs. The core measure—stripping out food and energy—rose to 2.5% from 2.2%, with services costs jumping to 3.5%. Traders expect policymakers to respond with an insurance hike next week, and markets have at least one additional move priced in by December. Traders expect policymakers to respond with an insurance hike next week, and markets have at least one additional move priced in by December. We think this risks becoming a policy mistake. The case for tightening against a still-moribund economic backdrop, in response to what may prove a transitory supply-driven shock, is flimsy — and looks coloured by the post-pandemic experience, when inflation was heavily demand-led and central banks were rightly criticised for moving too slowly.

The Japanese yen is flirting with the 160 threshold against the dollar once again, squeezed between elevated US yields, high crude prices and a still-cautious Bank of Japan. Authorities spent ¥11.7trn (roughly $74bn) intervening in foreign exchange markets between late April and late May to defend the currency, and although critics have called the effort largely ineffective — noting that it failed to generate sustained yen appreciation — it does appear to have enforced a line in the sand around 160. With roughly $1.3trn in reserves still available, Tokyo retains considerable firepower and appears willing to deploy it, with Finance Minister Satsuki Katayama warning last night “we stand ready to take appropriate action at any time, as needed”.

Here in Canada, the exchange rate is holding remarkably steady, reflecting relative stability in interest-rate differentials with the United States. We expect a neutral stance from the Bank of Canada when it meets next week for what would be a fifth consecutive hold: trade and investment uncertainties continue to weigh on domestic demand, the economy is running with abundant slack, and core inflation measures remain stable with expectations well anchored. We don't expect an explicit endorsement of the tightening bias still priced into markets. There is little reason for one.

In itself, we don’t see the upcoming United States-Mexico-Canada Agreement (USMCA) joint review posing a major fundamental threat to markets*. The trade pact is due for a six-year assessment on July 1, but missing the deadline would not be a crisis: if the three parties fail to sign off on an extension, the existing deal remains in force and they try again the following year. They have a decade of annual reviews in which to reach consensus before the agreement lapses in 2036. An outright withdrawal by Washington would hurt Canada and Mexico, but would also inflict damage on the United States, costing it duty-free access to its two largest export markets and taking a severe toll on industries in many Republican strongholds.

The psychological risks, however, could be significant. A deadline that passes without an extension will feed investor uncertainty, and overheated rhetoric from Washington—which is all but guaranteed—could deepen the paralysis already gripping Canadian businesses, triggering sharp sell-offs in the loonie. Currency traders are currently pricing in significantly less volatility in the Canadian dollar than in other major pairs. That could prove a mistake.

*The biggest occupational hazard associated with being a foreign exchange strategist is the fact that we can be proven wrong in seconds. Economists get a lot more time, especially if they fail to specify a date for their forecasts**.

**George Bernard Shaw put it well when he said "If all economists were laid end to end they would not reach a conclusion"***.

***Peter Lynch said "If all the economists in the world were laid end to end, it wouldn't be a bad thing"—which is just mean.

Market Overview

Data as of 7:15 AM EDT

Notes: DXY: Dollar index, ON: Overnight movement, DMA: Daily Moving Average, Pivot points are calculated on a one-month basis, 3-month and 10-year spreads are against USD, Implied V.: implied at-the-money option volatility

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