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Cognitive dissonance in markets begins to correct

Risk-sensitive currencies are giving back some of last week’s gains this morning, tumbling in the face of a resurgent dollar. US Treasury yields are climbing and the greenback is pushing higher as investors begin to question whether the Federal Reserve will cut rates aggressively without a “hard landing” in the economy next year. With unemployment inching up, consumer spending showing clear signs of exhaustion, and business capital expenditures shifting into reverse, the typical indicators of a recession are blinking red, and data out this week—today’s Institute for Supply Management services survey, and Friday’s November non-farm payrolls report—could provide more evidence of an incoming slowdown.

The Japanese yen is weaker after a report showed inflation decelerating more quickly than expected in November, further reducing pressure on the Bank of Japan’s easy-money policy framework. Consumer prices excluding fresh food climbed just 2.3 percent year-over-year in Tokyo last month, down from 2.7 percent in October and below consensus forecasts that had been set above 2.4 percent. The “core core” index, which more closely aligns with the core measure used in most industrialized countries rose 3.6 percent from a year earlier, down from 3.8 percent in the prior month.

A rate cut at the European Central Bank’s March meeting is almost fully priced in after Governing Council member Isabel Schnabel said further hikes had become “rather unlikely”. In an about-face for one of the most influential hawks on the central bank’s policy committee, Schnabel called last week’s inflation update—which showed price growth decelerating to 2.4-percent year over year last month—“a very pleasant surprise,” saying “Most importantly, underlying inflation, which has proven more stubborn, is now also falling more quickly than we had expected. This is quite remarkable”. Speaking with Reuters, she repeated a quip often attributed to John Maynard Keynes: “When the facts change, I change my mind. What do you do, sir?” – and the answer, for foreign exchange traders at least, is to sell the euro.

Australia’s dollar is under pressure after the central bank kept policy on hold at its last meeting for the year, pointing to cooling employment and falling inflation as reasons for caution. Governor Bullock said “Higher interest rates are working to establish a more sustainable balance between aggregate supply and demand… Holding the cash rate steady at this meeting will allow time to assess the impact of the increases in interest rates on demand, inflation, and the labour market”. Rate differentials are narrowing through the end of 2024.

The Canadian dollar continues to ratchet lower ahead of tomorrow’s Bank of Canada decision, with the consensus increasingly positioned for a “dovish hold” in which policymakers acknowledge signs of an economic slowdown and begin preparing markets for eventual rate cuts. There’s little doubt the economy is slowing—as suggested previously, the recent change in unemployment levels is indicative of an economy poised on the edge of a recession—but final domestic demand is strong, real estate markets are slowing at a relatively modest pace, and prices remain fairly sticky. Policymakers may work to forestall a premature easing in financial conditions by keeping rate hikes on the table and highlighting uncomfortably-slow progress on reducing underlying inflation pressures.

Thursday’s speech from Deputy Governor Toni Gravelle also represents a risk for dovish positioning in the short term – he may take a page out of Federal Reserve chair Jerome Powell’s playbook in warning markets against overpricing rate cuts. That said, the reality is that markets are overwhelmingly unlikely to take central bank rhetoric at face value, and will almost certainly return to betting on an aggressive pivot in short order.

TUESDAY

October’s Job Openings and Labor Turnover Survey should show a continued decline in the number of vacant positions, with roughly a quarter million listings likely subtracted from the 9.55 million available in the prior month. The quits rate will likely fall more precipitously as a growing sense of caution persuades workers to stop seeking greener pastures. (10:00 EDT)

WEDNESDAY

The Bank of Canada is widely expected to stay on hold until the early new year, with excess demand evaporating, economic growth stagnating, and inflation pressures showing clear signs of subsiding toward target. Policymakers have little choice but to remain rhetorically hawkish for now – according to central bank orthodoxy, price risks could flare up again at any time – but markets are likely to ignore this, with most investors remaining convinced the first rate cuts will begin by April 2024. (10:00 EDT)

FRIDAY

Economists believe the United States generated another 200,000 jobs in November. Unemployment is seen holding steady at 3.9 percent, and average hourly earnings are expected to tick 0.3 percent higher on a month-over-month basis, up from 0.2 percent in October. Assuming that the data isn’t terribly distorted by the resolution of the United Auto Workers strike, risks are somewhat tilted to the downside – but the unemployment rate still looks unlikely to rise enough to trigger the “Sahm Rule” recession indicator. Instead, signs of softness will likely be welcomed in markets. (08:30 EDT)

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