Markets are holding steady ahead of a week full of potential volatility landmines: central bankers in Tokyo, Washington and London will deliver rate decisions, four of the ‘magnificent seven’ technology companies – Amazon, Apple, Meta, and Microsoft – will release earnings, the euro area will publish an inflation update, and a critical US non-farm payrolls report will cap things off before the August doldrums set in. The dollar is edging higher, Treasury yields are slumping, and equity futures are setting up for a second day of gains after last week’s steep stock market selloff.
Investors remain unwilling to take short positions against the yen in the run-up to Wednesday morning’s Bank of Japan decision. The exchange rate has jumped almost 5 percent this month, with solid domestic price and wage pressures adding to slowing US inflation rates in supporting bets on an imminent narrowing in rate differentials, but market participants are wary, given that a more cautious approach from policymakers could easily prompt a reversal. Balance sheet changes are materially priced in after Governor Ueda telegraphed a “sizeable” reduction in the Bank’s bond purchase programme last month, and the likelihood of a hike in the policy rate remains difficult to assess, with domestic consumer demand growth seemingly failing to justify a more aggressive move off the lower bound.
The yen’s “safe haven” characteristics seem to be returning after dissipating during the early post-pandemic period. 90-day negative correlations between the VIX volatility index—Wall Street’s “fear gauge”—and the exchange rate look set to come back, with the 10-day measure already showing the yen rising whenever the VIX climbs. To us, this suggests that Japanese authorities have successfully introduced two-way exchange rate risk in their recent intervention efforts, that Japanese onshore investors are beginning to alter overseas asset deployment, and that carry traders are exiting yen-funded positions in a hurry whenever global risk sentiment takes a hit. If so, the “risk on, risk off” trading dynamics that drove currency markets between 2010 and 2019 could be on their way back.
Given the risks inherent in kicking off a sequential easing cycle too early, the Federal Reserve isn’t likely to modify its interest rate settings or balance sheet operations on Wednesday afternoon. Jerome Powell has avoided anything resembling an easing hint in recent comments, and his counterparts on the Federal Open Market Committee have clearly articulated a desire to see more data before pulling the trigger. In a July interview with the Wall Street Journal’s ‘Fed whisperer’ Nick Timiraos, New York Fed president John Williams said “I would like to see more data to gain further confidence inflation is moving sustainably towards our 2-percent goal,” saying “we’re actually going to learn a lot between July and September. We’ll get two months of inflation data. We’ll get quite a bit of information on the labour market, get a lot of information on things like consumer spending, business spending and what’s happening, also what’s happening around the world and how that factors into what’s happening in the US economy”.
Powell could open the door to a September rate cut nonetheless. By acknowledging signs of softness in any number of key fundamental variables—consumer spending, household savings rates, home sales, hours worked, unemployment rates, and core personal consumption expenditures—during the post-decision press conference, the Fed chair could subtly set the stage for a more explicit easing guidance at the Jackson Hole Economic Symposium in late August.
And Friday’s non-farm payrolls report could deliver more evidence of growing labour market slack. Markets think roughly 190,000 new jobs were added in July, with the unemployment rate holding at 4.1 percent, but academic opinion is slowly coalescing around the idea that strong immigration numbers have boosted the “breakeven” job creation rate beyond the 100,000 threshold that was once considered sufficient to keep the economy at full employment. We think a selling bias has emerged around the dollar, meaning that traders are ready to seize on anything that points to a decline in US yields ahead, suggesting that any number below the 175,000 mark could see the greenback losing altitude.
The pound is trading on a slightly softer footing ahead of the most perplexing rate decision in a long time. Inflation risks have clearly subsided—especially if volatile components like hotel fees are removed—and labour markets are cooling, even as real wage growth helps boost quarterly growth levels. But centrists on the Monetary Policy Committee remain hesitant: minutes taken during the June meeting characterised the decision to stay on hold as “finely balanced,” and although chief economist Huw Pill has described a “when-rather-than-if” outlook for rate cuts in comments earlier this month, he also said “I think it’s still an open question on whether the timing for a rate cut is now”.
A cut, especially if paired with dovish forward guidance, could trigger dramatic moves in the exchange rate. Markets are currently placing 50:50 odds on a move, with two cuts priced in for the remainder of the year, but with speculators crowded into long positions—speculative bets on the pound hit post-2008 highs last week—the risk of a “fast money” unwind looms large.
Here in Canada, the loonie is trading near an eight-month low, with last week’s surprisingly-dovish central bank decision keeping rate differentials firmly tilted against the currency across the front end of the curve. We think a broader easing in global yields—if maintained through this week’s raft of central bank meetings and the US non-farm payroll print—could lend some support in early August, assisting seasonal volatility dynamics in helping the exchange rate gain some altitude. But anticipated rate cuts are not materially altering Canada’s economic outlook: after years of unsustainably-fast property price appreciation, mortgage balances are too large relative to incomes, renewals continue to put upward pressure on borrowing costs, and investor interest in the country’s housing market is justifiably falling apart – as CIBC’s Benny Tal brilliantly explores here. With the global investment community now acutely aware of the household debt vulnerabilities built up in Canada over the last few decades, exchange rate gains should remain fundamentally limited.
