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Cautious Fed Messaging Puts Markets on the Defensive

The dollar is inching off a five week low after a slew of Federal Reserve officials repeated their “higher for longer” mantra in a series of appearances yesterday, forcing markets to push rate cut expectations a little farther out. The greenback weakened in recent weeks as a slew of softer-than-anticipated data releases pointed to slowing economic momentum, but gained slightly during yesterday’s session as Federal Open Market Committee members Bostic, Daly, Jefferson, and Mester all said they would need to see more evidence of cooling inflation before contemplating an easing in policy.

Markets are back to pricing in a little less than two rate cuts this year, Treasury yields are lower, and equity futures are holding steady ahead of the North American open as traders brace for more of the same today. Barkin, Barr, Bostic, Collins, Mester, Waller, and Williams will all make appearances in the coming hours, and it would be surprising if there are any material deviations from yesterday’s message.

Tomorrow’s May meeting minutes could shed light on the thought process behind the central bank’s decision to begin tapering its quantitative easing process, but the remainder of the discussion is unlikely to impact markets in any meaningful way. A series of softer-than-expected data releases in the intervening weeks have depicted an economy that is losing momentum, and fixed income investors have moved to put two rate cuts back on the table for the back half of the year. The June policy meeting, which will bring an update of the Fed’s “dot plot” summary of economic projections, should prove more dramatic.

It may be considered an indictment of how the modern financial system works, but Nvidia’s earnings release – scheduled for release after market hours tomorrow afternoon – could be the biggest factor in moving foreign exchange markets this week. Risk-sensitive currencies like the Canadian dollar that have exhibited growing correlations with US equity indices in recent years could come under selling pressure if demand for the company’s artificial intelligence chips surprises to the downside.

The euro is struggling to make headway against the dollar despite an ongoing improvement in underlying fundamentals. Data out this morning showed the bloc recording a goods trade surplus of 57.5 billion euro in the first quarter, up from -9.4 billion in the same period last year, with a -12.3-percent drop in imports fully offsetting a -3.2 percent decline in exports as energy costs came down. The exchange rate remains stuck within a remarkably-tight trading range, and there are no obvious catalysts for a breakout on the calendar this month – but the European Central Bank could pair a well-telegraphed June rate cut with some unexpectedly cautious guidance on future easing, helping to push the common currency back through the 1.10 threshold to the upside at some point.


Canadian markets are recovering from the “May 24” long weekend
– which is named after the 24-count “flat” of beers that all good patriots are obligated to drink in remembrance of Queen Victoria’s reign. The exchange rate is almost unchanged relative to Friday’s close as traders brace for this morning’s consumer price index number – which will mark the last major data release ahead of the Bank of Canada’s interest rate decision on June 5th. An upside surprise is possible – Canadian inflation conditions tend to be relatively well correlated with the US, where price growth has seen a modest re-acceleration – but if the data comes in on-consensus, we think the Bank will bow to softening economic conditions in delivering a long-awaited rate cut in June or July.

Aftershocks from the killing of Iranian president Ebrahim Raisi in a weekend helicopter crash are gradually fading in oil markets, with both major global benchmarks now roughly unchanged relative to Friday’s levels. Few expect the balance of power in the Middle East to shift dramatically, and elevated spare capacity levels within the OPEC cartel are helping numb markets to geopolitical risks. History suggests that the supply risk premium built into oil prices tends to fall when producers are capable of responding to potential crises – and sustained rallies are unusual during periods when unused output is high.

In the background, Treasury yields seem to be following typical seasonal dynamics, declining as outdoor temperatures heat up. The tendency for yields to fall between May and October – and to rise between November and April – has been documented in data back to the early fifties, and research published by the Critical Finance Review in 2015 showed that this “ does not arise due to macroeconomic seasonalities, seasonal variation in risk, cross-hedging between equity and Treasury markets, conventional measures of investor sentiment, the weather, seasonalities in the Treasury market auction schedule, seasonalities in the Treasury debt supply, seasonalities in the Federal Open Market Committee cycle, or peculiarities of the sample period considered”. Instead, “it is correlated with a proxy for variation in risk aversion linked to seasonal mood changes” – something familiar to currency traders, who have long observed a propensity for implied volatility levels to subside in the summer months and climb in the autumn. If this pattern holds, “carry trades” – in which funds are borrowed in low yielding currencies such as the Japanese yen, and invested in high-yielding alternatives like the Mexican peso – could gain momentum in the near term.

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