Volatility is reverting lower across the financial markets, even as investors swerve between opposing viewpoints on what the Federal Reserve will do next week. The dollar is back on the defensive, Treasury yields are slipping, equity futures are setting up for a modestly-positive open, and oil prices are climbing.
Odds on an outsized kickoff to the central bank’s easing cycle climbed yesterday after the Wall Street Journal’s ‘Fed whisperer’ Nick Timiraos summarised the current debate on the rate-setting committee in terms that seemed to favour a larger move. Referencing conversations with current and former officials, Timiraos said “The case for starting with a larger cut centres on taking out insurance against the risk the economy will slow down more under the weight of past increases at a time when officials no longer think such a slowdown is necessary to complete the job of bringing inflation back to their 2 percent goal”. Donald Kohn, vice chair from 2006 to 2010, was quoted suggesting that “risk management” concerns could tilt the balance toward a 50 basis-point cut.
The futures-implied likelihood of a half-percentage-point move at next week’s meeting has climbed to 45 percent, up dramatically from 15 percent two days ago, but down from the 98 percent hit just after the July non-farm payrolls report landed in early August. We don’t have a high-conviction view on the size of the first cut, but we’re not sure it matters much: as it stands, investors expect a total of 10 quarter-point rate cuts between now and January 2026 – which admittedly seems extreme given that recession probabilities remain quite low – but isn’t terribly out of line with recent easing cycles. The greenback’s yield advantage is likely to shrink in the near term, even if policymakers initially opt to move more carefully.
In contrast, both the European Central Bank and Bank of England are seen moving more slowly, cutting from lower starting points and moving toward “terminal” levels at a more gradual pace. The euro and pound have edged higher over the last two months on a narrowing in expected rate differentials, and policymakers on both sides of the Channel seem content to remain in data-dependent mode, taking decisions one at a time and avoiding the sort of auto-pilot easing campaign that could ensue in the United States beyond the early autumn. The pound looks marginally overpriced relative to the euro, but support for both currencies should remain intact in the absence of a dramatic slowing in the US economy – which would undoubtedly have global spillovers – or a major shock in the November presidential election, given its implications for growth, inflation, and trade around the world.
The Bank of Japan remains a clear outlier, remaining on a tightening trajectory even as anaemic growth and inflation levels restrain its room for manoeuvre. Rate expectations have risen sharply in recent weeks in response to a consistently-hawkish tone from policymakers, and evidence of a slowing US economy has contributed to a remarkable narrowing in cross-Pacific rate differentials, helping push the dollar-yen exchange rate closer breaking stiff psychological resistance at the 140 mark. Market participants are growing increasingly bullish, with Japan believed to be on the cusp of achieving a sustainable growth trajectory even as it reacquires its safe-haven credentials. We’re somewhat in agreement with this view – signs of improving momentum have been evident for a long time – but would caution that Japanese fundamentals remain structurally weaker than in competitor economies, and that a rising exchange rate could easily alleviate imported inflation pressures, forcing officials to move less aggressively in tightening policy over the year ahead.
Early September’s tactical rebound in the Canadian dollar seems to have run its course, with this morning’s modest improvement in West Texas Intermediate prices doing very little to provide lift. As suggested yesterday, the currency’s correlation with the North American oil benchmark has risen in recent weeks, but hasn’t yet displaced much tighter relationships with the S&P 500 – or the US ten-year Treasury yield – which remain far more important in driving price action.
As a small, open economy with an extraordinarily-indebted household sector, Canada is exceptionally sensitive to changes in global risk appetite and interest rates – both of which are primarily determined in US financial markets. This was exemplified in data released yesterday, which showed interest payments swallowing 9.59 percent of household disposable incomes in the second quarter, hitting levels last seen in 1992, and reflecting both the large denominators involved – Canadian consumers owe more as a share of gross domestic product than their counterparts in any other G7 country – as well as the sharp increase in global borrowing rates that has occurred over the last year. It remains difficult to imagine consumer spending rebounding in a meaningful way as long as global interest rates remain elevated, and the country’s vulnerability to shifts in cross-border capital flows will likely remain acute until a deleveraging cycle has run its course, meaning that the Canadian dollar will continue to dance to a tune played elsewhere.
