Market Brief: Risk Appetite Rises Ahead of US Inflation Print

Investors are struggling to restrain themselves ahead of consumer inflation data that is expected to help clear the way for a jumbo-sized rate cut from the Federal Reserve in September. Treasury yields are sliding, equity indices are setting up for a positive open, and risk proxies like the Canadian dollar are advancing as market participants double down on a soft landing scenario in the US.

The trade-weighted dollar is down roughly half a percentage point from Monday’s level after producer prices rose by less than forecast in July, pointing to a continued easing in underlying inflation pressures. The core producer price index—with highly-volatile food and energy inputs removed—was unchanged on a month–over-month basis, marking its weakest print in four months, and the headline measure advanced just 0.1 percent, undershooting market expectations. Wholesale and retail markups—as defined by the “trade services in final demand” measure—saw the second-largest monthly decline on record, and turned negative year–over-year as consumers turned more cautious and baulked at paying higher prices.

Economists think this morning’s consumer price index report will add to greenback weakness, with the core measure increasing at the weakest three-month pace since 2021, reinforcing market bets on an intense easing cycle beginning next month. Both headline and core inflation gauges are seen rising 0.2 percent in July relative to the prior month, with discretionary spending categories retreating and the shelter and used-car segments adding to downward pressure on prices. Interest-rate futures currently imply a 52-percent chance of a half-percentage point cut on September 18, with further calibration likely to come in the coming minutes.

But softening inflation could ultimately weigh on other aspects of the ‘US exceptionalism’ trade. If a narrowing gap between input costs and selling prices begins to put downward pressure on corporate operating margins, the extent to which America’s equity markets outperform their global counterparts could shrink, weakening demand for the dollar. Even after last week’s correction, the country’s stock market capitalisation has risen by more than $21 trillion dollars since January 2020, creating almost three times as much paper wealth as the rest of the world, combined. For a slew of reasons, we doubt this can be sustained.

The British pound fell a few basis points early this morning after inflation decelerated more than expected in July, slightly increasing the likelihood of another rate cut by the Bank of England’s November meeting. Headline consumer prices rose a softer-than-forecast 2.2 percent year-over-year, while services inflation—monitored closely by policymakers—declined to 5.2 percent, down from 5.7 percent in the prior month. Data out yesterday showed ex-bonus wage growth slowing to a two-year low, helping bolster confidence in a more aggressive monetary easing trajectory ahead - but still-favourable rate differentials are helping insulate the currency against selling pressure.

The Japanese yen is down modestly after Prime Minister Fumio Kishida said he would step down as leader of the Liberal Democratic party in September, effectively handing the reins to the prospective winner of an internal party election. Kishida’s approval ratings had hit historic lows after a series of policy missteps, including a funding scandal that brought down four of his cabinet ministers, but a cost-of-living crisis—exacerbated by a weak yen—also played a critical role, potentially meaning that his successor will put more pressure on the Bank of Japan and Ministry of Finance to help support the exchange rate.

The Mexican peso, benefitting from a broad-based recovery in risk appetite and a “Goldilocks” outlook for the American economy, is advancing against the dollar, with further upside possible in the coming hours if US consumer price growth remains restrained. Policymakers at the country’s central bank last week voted by a 3-to-2 margin to deliver the year’s second rate cut, downplaying recent currency weakness while warning “The balance of risks to growth of economic activity remains biased to the downside”. Volatility has risen, but three-month rate differentials—key in sustaining carry trade flows—remain spectacularly wide, suggesting (to us, at least) that speculators are likely to return.

More broadly, carry traders appear to be dipping their toes back in after last week’s washout, with a number of high-yielding currencies rebounding over the last few sessions. From Latin America through Asia and the Middle East, the biggest target units are still sitting on positive year-to-date returns, and look poised for further gains in the short term - at least until another volatility shock changes funding conditions.

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