Foreign exchange rates are settling into narrower trading ranges this morning as political risks ebb and the dollar’s retreat continues.
The euro is modestly lower after an alliance of left-wing parties achieved a stunning upset in the French election, making a “hung parliament” – in which no single group can dominate the legislative agenda – the most probable outcome. Defying polls that showed Marine le Pen’s Rassemblement National on track toward gaining the biggest delegation in the National Assembly, Jean-Luc Mélenchon’s Socialist Nouveau Front Populaire is leading with 182 seats, with most constituencies counted, followed by President Emmanuel Macron’s Ensemble centrist alliance with 168. Le Pen’s far-right party looks set to capture just 143 seats, less than half the 289 needed to secure an outright majority.
France is still facing months, if not years, of political uncertainty, with negative implications for the country’s business climate and financial position. Massive spending initiatives are unlikely to pass, but under almost any conceivable coalition government, Macron’s deeply-unpopular pension reforms will come under threat, proposals for raising taxes will gain support, and frictions will increase with Brussels over the country’s worsening debt outlook. This suggests that the spread between ten-year French government bonds and their German equivalents might not revert to pre-election levels, and that the euro’s embedded risk premium could linger as markets grow increasingly wary of the rot at the centre of the common currency area.
With ‘No Drama* Starmer’ settling into Downing Street, the pound is extending its winning streak against both the euro and dollar. The currency has emerged as the strongest performer in the G10 this year on an exchange rate-positive stance from the Bank of England, and the prospect of a more stable Labour administration. Further gains look likely as British financial markets reassume some safe haven characteristics, but we think gains could slow as it becomes clear that the new government doesn’t have enough fiscal space to enact broad-reaching economic reforms or new spending initiatives – at least not without raising taxes. Speeches from newly-appointed cabinet members, and from central bankers – especially chief economist Huw Pill – over the coming days could trigger renewed turbulence.
This week should see currency markets enter their typical summer lull as trading floors empty out – but several event risks could punctuate the calm.
Markets will be on alert tomorrow morning when Federal Reserve chair Jerome Powell delivers his semi-annual monetary policy report in front of the Senate Banking Committee. He may continue to strike a balanced tone, emphasising the central bank’s data-dependent reaction function and refusing to be drawn on the prospects for easing ahead. This might lend the dollar some support. But, in contrast with many of his appearances through the early part of the year, we expect a heightened focus on the downside risks emerging in the US economy, and think markets could add to wagers on an interest rate cut in September, raising implied odds beyond today’s circa-75-percent level.
Friday’s payrolls data showed the US economy moving closer to a slowdown, with rising unemployment aligning with the previous week’s core personal consumption expenditures index in bolstering the case for rate cuts beginning in the early autumn. Thursday’s June consumer price index report should bring more of the same, with headline price growth seen slowing to 0.1 percent on a month-over-month basis, core inflation remaining at levels consistent with the Fed’s target. When calculated using the same method as in other major economies – on a so-called harmonised basis – the US all-items annual inflation rate was running at less than 2 percent in May, in line with the UK, and below its equivalent in the euro area, and there’s nothing to suggest that price pressures have intensified in the interim. Policy easing is coming.
The Canadian dollar remains on the defensive after a disappointing June jobs report helped bring a July rate cut into closer focus. Total employment shrank by 1,400 in the month, undershooting the 25,000-job consensus, and the unemployment rate climbed to 6.4 percent from 6.2 percent, with weakness concentrated in the most interest-rate sensitive areas of the economy. Annual wage growth accelerated, from 5.2 percent to 5.6 percent, but we think this was largely driven by base effects and continued gains in public service sector salaries – hardly indicative of strong underlying growth.
One could be forgiven for thinking that this would lead to a dramatic change in rate differentials between the US and Canada. But investors see the gap between US and Canadian policy rates – currently at 0.63 percent when calculated from the mid-point of the Fed Funds target range – shrinking to 0.54 percent in a year, and then gradually widening out again to 0.62 percent in three years. This is vanishingly small, particularly when compared with most other major trading blocs, where policy rate differentials are expected to narrow sharply over the coming years. We doubt this will hold, given the damage that could be inflicted on the Canadian economy in the years ahead if the real estate growth engine stays in low gear, but suggests that markets currently believe that policymakers at the Bank of Canada spend their time talking about hockey, placing orders at Tim Horton’s, and following the Fed’s decisions in lockstep.
