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Dollar Steamroller Keeps Going

It’s not July 4th yet, but fireworks are going off in the financial markets.

The dollar has risen sharply in line with a surge in Treasury yields over the last three sessions after a dismal performance from President Biden in Thursday’s televised debate triggered a dramatic reappraisal in the odds on a Republican sweep. With former president Trump cruising toward a second term and his party seen gaining control over both houses of Congress, markets think increased tariffs, reduced immigration, and lower taxes will lead to higher inflation, larger deficits, and more Treasury issuance. Breakeven inflation rates – a measure of expected price growth derived from the difference between inflation-protected securities and their nominal counterparts – have jumped since the debate, and Treasury yields are up more than 20 basis points.

This comes despite a clear deceleration in underlying US economic data. Last week brought more evidence of a fading in job growth and inflation pressures, with unemployment claims rising and the Fed’s preferred price measure – the core personal consumption expenditures index – slumping to 0.083 percent on an unrounded month-over-month basis, marking its weakest pace since November 2020. The Citi US economic surprise index has fallen to its lowest levels since mid-2022, and the Atlanta Fed’s GDPNow estimate for second-quarter growth has dropped to 1.7 percent from 3 percent only a few weeks ago.

Data out this week could further bolster the case for a September rate cut. This morning’s Job Openings and Labor Turnover Survey report is likely to show the ratio of vacancies to unemployed workers fell to 1.2 – or below – in May, below the pre-pandemic peak at 1.22, and indicative of a rapid cooling in demand for workers. Tomorrow’s jobless claims data could continue to grind higher. And Friday’s non-farm payrolls report is expected to show overall labour market momentum slowing, with job creation and wage growth dropping in sequential terms.

To us, this suggests that the dollar’s strength could be vulnerable to correction. The greenback is the only major currency to have moved upward in an essentially uninterrupted fashion this year, blowing away all of its competitors as US markets have absorbed an ever greater share of global capital flows.

But it isn’t obvious where an alternative can be found.

The euro’s gains are eroding after a relatively strong session yesterday. The common currency gained when Sunday’s first-round election showed France’s National Rally party falling short of the support needed to dominate the government’s policy path. Parties on the centre and left are working to form a “front républicain,” dropping vote-splitting candidates in an unprecedented number of three-way races in an effort to ensure that a hung parliament emerges once the dust settles after the second round this weekend. But the far-right party led by Marine le Pen secured 11.5 million votes, far surpassing its rivals, meaning that an outright majority remains a possibility, and the country’s fiscal outlook looks set to continue its deterioration regardless of the victor.

Britain’s pound is faring better, yet potential gains look limited. With Keir Starmer’s Labour party sitting on a 21-point lead over their rival Conservatives going into Thursday’s election, investors are looking forward to a reduction in post-Brexit tensions with the European Union and a shrinking in the risk premium that has been embedded in gilt yields since the ill-fated Truss administration’s experiment with fiscal policy. But government finances remain tight, meaning that the fiscal impulse is unlikely to turn terribly positive in the immediate term, and there’s little sign of the sort of wage- or demand-driven price pressures that could derail the Bank of England’s easing plans in the months ahead. Data out this morning showed retail consumer inflation falling to a 32-month low, pushing the odds on an August rate cut above the 50-percent threshold.

The Japanese yen might have more short-term upside potential, but even if the government launches another intervention effort, gains will likely be capped well short of levels that would generate generalised weakness in the dollar. The exchange rate is knocking on the 161.50 level in interbank markets, raising the risk of another round of purchases from the central bank, but this will undoubtedly be aimed at reducing volatility, not trying to reverse the currency’s slide. The Bank of Japan looks unlikely to deliver more than a modest adjustment in its policy settings – perhaps a relatively small reduction in bond buying and a rate hike – at its July meeting, rate differentials remain vast, and the yen’s role as the funding currency of choice for global carry trades remains effectively undiminished.

And here in Canada, where much of the country is still sleeping off yesterday’s festivities, there isn’t much to celebrate on the growth front. After having entered the post-pandemic monetary tightening cycle with vastly higher rate sensitivities – due to higher debt burdens and shorter-term mortgages – than their American counterparts, Canadian households are struggling to power the economy, and growth remains well below trend. With Friday’s advance estimate for May gross domestic product growth in hand, it looks as if the Canadian economy remains 2.3 percent smaller than the pre-pandemic course would suggest, amounting to almost $298 billion dollars (2012 terms) in lost output. The bull case for the loonie remains seriously challenged.

For now, it’s the dollar’s world, we’re just living in it.

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