Market Brief: Markets take potential shutdown in stride, dollar recovery shows signs of exhaustion

Markets are beginning the week on a stubbornly-optimistic footing as investors shrug off the possibility of a US government shutdown and bet on continued growth in the world’s largest economy. Equity futures are climbing ahead of the North American open, benchmark Treasury yields are pulling back from last week’s highs, and the dollar is retreating against most of its major rivals on a broad-based recovery in risk appetite.

The US consumer remains remarkably strong. A series of data releases at the end of last week showed spending activity holding up far better than anticipated, suggesting that the spending engine powering the American economy has barely slowed in the face of a historic rise in policy uncertainty. Second-quarter gross domestic product was revised up to show output growing at the fastest pace in almost two years on a surprise increase in household consumption, durable goods orders jumped more than expected in August, and personal income and spending topped forecasts. The Atlanta Fed’s GDPNow forecasting model is now putting third-quarter growth at 3.9 percent, up from 3.3 percent previously.

Easing expectations have moved in a more realistic direction. Although pricing for a move in October is holding firm around the 90-percent threshold, traders have grown more sceptical of the need for dramatic rate cuts in the new year, and Treasury yields have climbed off their lows. Speculative positioning against the dollar has eased, with long bets on the euro and yen pulling back from arguably-overextended levels.

It is notable, however, that short bets against the Canadian dollar remain elevated, and that the exchange rate itself is holding near levels that typically indicate oversold conditions. The loonie is trading far below the theoretical conversion rate that equalises the purchasing power of different currencies by adjusting for price level differences—the purchasing power parity exchange rate—suggesting that risks are biased to the upside over the long run*.

The greenback correction could lose a little momentum in the coming days. Tomorrow’s Job Openings and Labor Turnover update could bring more evidence of a softening in demand for workers, with vacancies declining and the ratio of open roles to unemployed workers continuing its long descent. The Conference Board’s consumer confidence report might exhibit modest signs of improvement, but will also join last week’s University of Michigan equivalent in bearing the imprint of growing concerns over inflation and employment. If September’s Fed surveys are anything to go by, Wednesday’s Institute for Supply Management manufacturing purchasing manager index should show demand for factory-made goods weakening. And Friday’s non-farm payrolls report is unlikely to bring signs of a recovery in job-creation rates, especially given that federal government employees with early-retirement packages should begin rolling off. Economists think 50,000 jobs were added in September, with the unemployment rate holding at 4.3 percent, but risks are tilted to the downside.

If we get the payrolls report, that is. The US government is barrelling toward a shutdown on Wednesday, and although we don’t expect a significant impact on the economy itself, it is possible that the release is delayed. Past episodes suggest the drag on growth—from the furloughing of federal workers, delays in contracts and permits, and a temporary dent in household spending—should be fairly modest—a few tenths of a percentage point for each week the government is closed—and could be largely reversed once operations resume. Yet we have seen statistical reports postponed during previous instances, and something similar cannot be ruled out this time.

For markets, US government shutdowns are typically more farce than tragedy**. Equities usually wobble before rebounding, bond yields stumble and then recover, and moves in the dollar are typically indistinguishable from background noise***. The 2013 and 2018–19 episodes left no deep scars. But stock market valuations are in rarefied territory, corporate bond spreads are remarkably tight, and implied currency volatility expectations are unusually low. Another hit to confidence in America’s political system could act as a destabilising influence, driving a new flight to safety among market participants who have become inured to chaos in Washington.

Please note: Travel commitments will prevent Market Brief distribution tomorrow and Wednesday. We will return on Thursday morning.

*It should be noted that exchange rates regularly deviate from purchasing power parity calculations for years at a time, meaning that such measures only "work" over long time horizons.

**As Karl Marx put it, “History repeats itself: first as tragedy, second as farce”.

***Yes, we've seen charts put out by major banks purporting to show the dollar falling in line with government shutdowns. No, we're not confident they are free from confounding variables, or that any past reaction is likely to repeat, given that US Treasury markets remain the world's safe haven of choice.

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