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Dollar Advances, Euro Retreats On Rising Political Risk

The dollar is holding near five-week highs this morning as Federal Reserve rate cut hopes continue to fade and renewed political uncertainty roils the euro area. Equity futures are setting up for a more subdued open, Treasury yields are down on safe-haven flows, and commodity prices are broadly lower.

Friday’s non-farm payrolls report forced traders to push the expected initiation of the Fed’s easing cycle further into the future. Job growth surged, with a 272,000-position gain topping market expectations, and wage growth accelerated, rising 0.4 percent month-over-month. Overnight index swaps are currently pricing in 36 basis points in easing by December, meaning that the Fed will likely become the last Group of Seven central bank to get off the starting block this year.

Federal Reserve officials are likely to raise their own policy outlook at Wednesday’s meeting, with the “dot plot” summary of economic projections pointing to two or fewer rate cuts before year-end, down from the three assumed in March. With labour markets remaining strong, consumer spending essentially undiminished, and inflation easing only gradually, Chair Jerome Powell may use the post-decision press conference to outline a slower, more cautious easing cycle ahead. This stance should keep rate differentials – which currently favour the dollar relative to its developed-market counterparts – elevated for now.

Mexico’s peso is coming under renewed pressure after preliminary election results showed the ruling coalition coming very close to achieving a supermajority in the upper house of Congress. According to the party president, Morena and its allies captured 372 seats in the 500-member lower house of Congress, well above the two-thirds supermajority threshold, and will control 83 seats in the 128-seat Senate – meaning that only two opposition votes will be needed to enact constitutional changes. The final structure of the legislature will remain unclear until August, when proportional seat shares will be assigned – and with recounts likely to take place in the interim, the underlying calculus could shift.

The exchange rate plunged last week on fears the leftist governing party could eliminate independent regulators and move to appoint judges and election officials via popular vote, making them vulnerable to political pressure. Businesses in Mexico think that this will leave them unprotected against government action in the future, and outside observers believe the “nearshoring” trend could slow as political uncertainty weighs on investor appetite.

We’re not sure this level of fear will persist: comments from lower house leader Ignacio Mier and current president Andrés Manuel López Obrador notwithstanding, we suspect Claudia Sheinbaum will take action to calm markets and restore party discipline in the weeks ahead. And with implied volatility ramping higher, the central bank – Banxico – is seen holding rates at elevated levels for longer, potentially bolstering the currency’s appeal to carry traders.

The euro is trading near its weakest levels in a month as political risks climb. Although centrist coalitions preserved their majorities in European Parliament elections over the weekend, far-right parties made serious headway in Germany and France. With Marine Le Pen’s National Rally party capturing more than twice as many votes as the ruling party, president Emmanuel Macron called a parliamentary election for the end of this month, suggesting that he seeks to force the electorate into making a choice between stability and a more radical – and potentially less coherent – vision for Europe’s future. Macron will remain head of state until the next presidential election in 2027, but might be forced to work with an unfriendly prime minister and legislature in the interim.

We had expected a modicum of strength in the euro as the US economy slowed, but the common currency is notoriously allergic to political uncertainty. Bond spreads between core and periphery countries are likely to widen until the political morass is navigated, and the dollar-euro exchange rate could remain under pressure until August, when we think evidence of a slowing US labour market will translate into more dovish rhetoric from Fed officials.

Canada’s loonie is still on the defensive after Friday’s morning’s trading action saw it lose almost 40 basis points against the greenback. The country’s labour market is unquestionably in worse shape than its US counterpart: our localised derivation of the Sahm Rule – which states that the economy is likely in recession when the 3-month moving average level of unemployment climbs 0.8 percentage point above its 12-month low – triggered back in October, and joblessness has only increased in the intervening months. But it is also clear that the exchange rate is mostly reacting to developments in US fixed income markets – it outperformed on the crosses as the twin employment releases hit the tapes, and remains stronger than many of its international counterparts.

An incredibly busy week beckons, with event risks hitting in rapid succession over the coming days. Tomorrow will bring wage numbers from the UK, followed by the OPEC monthly report. US inflation data for May will drop on Wednesday morning, setting the stage for the afternoon’s Fed decision and press conference, and Thursday’s US producer price index could provide insight into how underlying pressures are evolving. Volatility should remain elevated relative to recent history.

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