Market Brief: Jackson Hole aftermath keeps dollar supported

The dollar is edging off highs reached last week as traders digest Friday's hawkish tilt in Fed communications, monitor developments in oil markets, and brace for a slew of event risks in the days ahead. Ten-year Treasury yields are holding near their highest levels since early last year, equity markets are setting up for modest declines at the open, and most major currencies are inching higher in convictionless trading.

Odds on a rate hike at the Federal Reserve’s September meeting jumped after chair Kevin Warsh underscored a hawkish tilt among policymakers in Friday’s address at the Jackson Hole economic symposium. In remarks echoing recent statements from many of his counterparts, he downplayed risks in the labour market, suggesting the supply of and demand for workers are roughly in balance; warned that price growth was showing no sign of returning to target; and said “We must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed. Otherwise, we have work to do”. The likelihood of a September move jumped to about 61%, up from 35% ahead of the speech, and 2.2 rate hikes are now implied in Fed funds futures over the next year, up from 1.8 early last week.

Treasury curves flattened as the chair provided more insight on the Fed’s operating framework. Though he made light of the suggestion that he was offering “forward guidance”, Warsh worked to correct missteps in his earlier communications by providing greater clarity on the Fed's reaction function—its approach to setting policy in response to shifts in economic conditions. He confirmed that the central bank will continue to target a 2% annual rise in the core personal consumption expenditures index, and that the Fed funds rate—not the balance sheet, forward guidance, or tighter financial conditions—would remain its primary tool. In comments interesting to the closeted monetarists among us*, he also said “we should pay attention to money created by the central bank and money that comes from the banking and financial systems,” noting he currently would be “hard pressed to describe broad financial conditions as 'restrictive'”**.

Brent crude is trading above $90 a barrel once again after US forces struck two Iranian rocket launchers on Larak Island—its first known military action since late July—and Tehran retaliated with missile attacks on American facilities in Jordan. President Trump later claimed that Kharg Island, home to Iran's main oil-export terminal, was “being blown to smithereens”, though there has been no confirmation that any such strike took place***. Markets have grown less sensitive to conflict-related headlines, but exports from the region are thought to be running at about a third below their pre-war level, and worldwide inventories are well below historical norms, raising the risk that a renewed intensification could unleash second-round effects on the global economy.

This week’s macroeconomic calendar is packed with top-tier events:

In Europe, tomorrow's August inflation release will help solidify expectations ahead of next week's European Central Bank meeting. Consensus forecasts suggest annual price growth in the euro area jumped to 3.2% from 2.9% as energy prices climbed, while the core measure—excluding more-volatile food and energy categories—is seen holding at around 2.5%, well above the central bank's target. The broader European economy has shown surprising resilience in recent months, suggesting officials will feel comfortable tightening policy slightly—but we believe they will err on the side of caution in the accompanying communications, avoiding telegraphing further moves as they wait for more data.

No one expects the Bank of Canada to adjust rates at Wednesday's meeting; markets will instead focus on how policymakers characterise the balance of risks to the central bank's price stability mandate. Recent data releases have shown the Canadian economy recovering, with healthy consumer demand, stronger business investment, and robust exports translating into firmer employment and growth. But with overall output still well below potential and trade skirmishes with America hardening into all-out war, there is no sign of demand-led inflation, no hint that price expectations are becoming unanchored, and no evidence of a dangerous loosening in financial conditions. We think policymakers are likely to acknowledge mounting downside risks and play down the prospect of an inflationary overshoot—but we are not alone in that view, so market reaction will be determined by the extent to which officials manage to out-dove expectations****.

In the US, the latest manufacturing, services, and Beige Book surveys will offer useful insight into how conditions are evolving, but investors are likely to fixate on labour-market data ahead of the September 16 Fed decision. Tomorrow’s Job Opening and Labor Turnover report, Wednesday's ADP private payrolls estimate and Thursday's weekly jobless claims will all build anticipation ahead of Friday's August non-farm payrolls report, where economists think payrolls will climb by 58,000 positions, after a shock contraction of 23,000 in July, with the unemployment rate holding at 4.1%.

In a break with the past, we suspect any sustained reaction in the dollar will hinge on the jobless rate rather than the headline jobs number. After Kevin Warsh joined several of his counterparts in arguing that a shrinking supply of workers—the result of demographic change and lower immigration—has lowered the “break-even” pace of hiring needed to keep the labour market in balance, the monthly average job growth now required to reassure policymakers that they are meeting their employment mandate has probably fallen well below 50,000. So while a surprise jump in the unemployment rate could send expectations tumbling, rates lower, and the dollar into a renewed tailspin, a steady print is likely to clear the way for a September hike and keep the greenback well-bid.

*I'm not a Milton Friedman-style monetarist, but it is difficult to argue that the post-pandemic surge in money supply didn't play a role in lifting inflation.

**To put this more clearly, wealth effects and credit creation in the financial system are still creating abundant liquidity, which is flowing into demand across the economy. This is likely helping keep prices aloft.

***Admittedly, the president has been experiencing difficulty with place names.

****A sell-the-rumour, buy-the-fact reaction is possible in the Canadian dollar if the Bank's communications match already-dovish expectations.

Market Overview

Data as of 7:15 AM EDT

Notes: DXY: Dollar index, 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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