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Dollar powers higher on rising rate expectations and sustained liquidity demand

Yields and the dollar continue to push higher after minutes taken during the Federal Reserve’s May meeting seemed to show policymakers questioning whether regional bank turmoil would meaningfully slow inflation. According to a record published yesterday, “Several participants noted that if the economy evolved along the lines of their current outlooks, then further policy firming after this meeting may not be necessary,” but “Some participants commented that, based on their expectations that progress in returning inflation to 2 percent could continue to be unacceptably slow, additional policy firming would likely be warranted at future meetings.”

Speaking at an event earlier in the day, Governor Christopher Waller said “whether we should hike or skip at the June meeting will depend on how the data come in over the next three weeks”. Markets are leaning toward a hawkish “skip,” with odds on a June rate hike hovering near the 32-percent mark while the likelihood of a July move is above 60 percent.

The German economy tumbled into a technical recession in the first quarter,with consumers cutting spending to cope with higher food and energy prices, and export growth slowing in response to a weaker-than-expected rebound in China. The euro is down against the greenback, but higher domestic bond yields suggest investors don’t expect the European Central Bank’s trajectory to shift in response – instead, dollar-centric factors are likely playing a bigger role in driving currency market price action.

The pound is struggling to make headway against the dollar and euro despite a significant improvement in relative rate differentials. Yesterday’s searingly-hot inflation print has driven markets to bet on the Bank of England raising benchmark rates to 5.5 percent before the end of the year – a level that would require at least four quarter-point hikes, and could impact economic growth. Investors worry that stagflationary outcomes are possible in a country that has deliberately limited access to immigrant labour and goods from Europe, weakening the pound’s purchasing power on global markets.

The Canadian dollar is little changed after payrolls fell by just -9,900 positions in March, following a 37,900 increase in February. Numbers just published by Statistics Canada show average weekly earnings up 1.4 percent year-over-year, down from 1.9 percent in the previous month as base effects continue to play havoc with annual comparisons. Perhaps more importantly, the number of job vacancies fell roughly -2.1 percent in the month, suggesting that labour market tightness is beginning to diminish and giving the Bank of Canada room to stick to its “wait and see” approach for another month or more.

And debt ceiling concerns hit the headlines again last night after Fitch Ratings announced that it had put the US on “rating watch negative,” saying, “the brinkmanship over the debt ceiling, failure of the US authorities to meaningfully tackle medium-term fiscal challenges that will lead to rising budget deficits and a growing debt burden signal downside risks to US creditworthiness”. DBRS Morningstar followed suit this morning, and the other major agencies are likely to tread a similar path in days to come.

We’re not sure this matters. In the years since the global financial crisis demolished ratings agency reputations, developed-economy bond yields have become increasingly disconnected from estimates of creditworthiness, with liquidity demands and broader economic imperatives routinely overriding ratings actions in determining long-term interest rates. The pension plans, insurers, global banks, and foreign governments that – along with the Federal Reserve – are the biggest players in the Treasury market, are unlikely to shift buying activity in response to a downgrade.

But the risk of a technical default is real, and we suspect that markets remain complacent about the distortions that could emerge if US debt payments are disrupted. Although there are clear signs of rollover risk in short-term Treasury bills, stock markets are sitting on solid gains, the VIX “fear index” remains well within normal ranges, implied volatility in the foreign exchange markets remains restrained, and cross currency basis swaps – which typically act as a proxy for global dollar funding concerns – are showing no evidence of stress. All of this could change if investors begin to doubt, even momentarily, House Speaker McCarthy’s ability to garner support from the right-wing House Freedom Caucus (a group that seems unlikely to respond to polling pressure) for a deal that might involve spending compromises.

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