Market Brief: Trading Ranges Shrink As Fed Decision Looms

Happy Fed Day to all who observe. With hours to go before the world’s most powerful central bank delivers its first post-pandemic rate cut, investors still have no clarity on how big it will be. The dollar is flat, Treasury yields are little changed, and North American equity indices are setting up for modestly-stronger open, as market participants cut risk into what could be characterised as the most deeply-untradeable announcement in recent memory.

Data released yesterday morning refused to conform with the imminent-slowdown thesis. So-called control group retail sales - which exclude food, cars, gasoline, and building materials - climbed 0.3 percent in August, and industrial production moved back into positive territory with a 0.8-percent expansion - not consistent with a strong acceleration, but also not consistent with a recession. The Atlanta Fed’s GDPNow forecasting model was revised up to a seasonally-adjusted annual rate of 3 percent - from 2.5 percent previously - suggesting that the economy is on track for another quarter of above-average growth.

To us, risk management considerations suggest that a larger move is slightly more likely. Key measures of underlying inflation have fallen into the Fed’s target range, and the labour market is showing early signs of softening. There is ample room to recalibrate the level of restrictiveness built into the current effective Fed funds rate - which at 5.38 percent, is well above the pace of underlying inflation - and there’s no evidence of credit imbalances that might discourage a more decisive move down to neutral - currently estimated at around the 2.75-percent mark.

Although “dollar smile” dynamics remain intact, the greenback is looking tactically oversold. The world’s most dominant currency is likely to fall over time if volatility remains low and global growth differentials continue to narrow. But speculative positioning is unremittingly bearish, traders are crowded into long positions on lower-yielding currencies elsewhere, and the repricing in short-term policy expectations that ensued after the July non-farm payrolls report looks seriously overextended. A short-term snap higher cannot be ruled out.

The British pound is outperforming the euro and Japanese yen after services inflation came in slightly higher than expected in August, diminishing odds on a clear dovish signal emanating from tomorrow’s Bank of England meeting. The closely-watched services basket accelerated to 5.6 percent year-over-year in August - up from 5.2 percent in July - suggesting that policymakers could maintain a more cautious stance in tomorrow’s vote and associated communications. However, with headline consumer price growth holding at 2.2 percent, and other indicators pointing to a loss in economic momentum into the third quarter, traders remain broadly convinced that a steep easing cycle beckons, with two rate cuts priced in before year end, to be followed by at least five next year.

Odds on a 50 basis-point rate cut at the Bank of Canada’s October meeting are creeping higher after Statistics Canada said its consumer price index increased 2 percent in August, slowing dramatically from the prior month’s 2.5-percent pace. Mortgage interest and rental costs contributed the bulk of the headline print, and the share of spending categories generating above-target inflation fell in the month, while those experiencing deflation held near 38 percent.

To us, there are no meaningful obstacles preventing a more aggressive move down to neutral. With inflation quiescent, consumer demand continuing to weaken, jobless rates ratcheting higher, and a 2009-style energy investment cycle looking distinctly unlikely, Canada’s policymakers could see a jumbo-sized cut from the Fed as preparing the psychological ground for something similar at their own October meeting. This means that the Canadian dollar could - perhaps counter-intuitively - fall even if the Fed hits US short-term rates with a sledgehammer in today’s decision.

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