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Easing Wagers Pull Back Slightly as Wariness Returns

Not so fast. Currency markets are turning more cautious this morning as traders trim US rate-cut bets slightly from levels hit after Wednesday’s Goldilocks-esque inflation and retail sales reports. The greenback is inching up against its major counterparts, long-end Treasury yields are pushing higher, and North American equity futures are setting up for a slightly diminished open.

But the dollar’s outperformance has faded in recent weeks. After a series of data releases showing labour markets slowing, consumer spending trending down, and inflation pressures subsiding, economists are revising growth projections lower. Federal Reserve chair Jerome Powell’s repeated reference to “restrictive” rate settings have added to perceptions of an easing bias among policymakers, helping sustain expectations for an easing cycle ahead. On a trade-weighted basis, the dollar has declined more than 2 percent from its mid-April highs (the DXY index is not trade-weighted, and arguably should be discarded in favour of other measures), and speculative positioning is beginning to shift toward punts on rival currencies.

Traders remain cautious on the euro, but the fundamentals underpinning the common currency are showing signs of improvement. Inflation is nearing the European Central Bank’s 2-percent target, and investors are expecting rate cuts to come in June, September, and December, but the bloc’s current account has improved substantially from levels hit after the invasion of Ukraine, upside risks are multiplying, and economic data releases are consistently outperforming forecasts, widening the gap against the United States. This won’t necessarily translate into significant gains in the exchange rate – false dawns have been seen before, and a dramatic move above the 1.10 threshold should be regarded with suspicion – but could put a floor under the currency, giving it room for outperformance, particularly if Madame Lagarde delivers a “hawkish cut” at the June policy meeting.

China’s effort to reduce leverage in its property sector – arguably one of the biggest bubbles in human history – appears to be reversing. Beijing last night announced a raft of measures meant to support real estate markets, including removing a floor on mortgage rates, lowering down payment requirements, and providing funding for state-backed firms to purchase unsold inventory from developers. In the short term, the moves are helping support equity markets and boost appetite for the renminbi, but implicitly represent an admission of failure on the part of authorities who have spent much of the last seven years trying to forestall an eventual balance sheet collapse of the type that followed Japan’s debt bubble in the eighties, and in the US after the 2008 financial crisis. As we, and academics like Michael Pettis have long argued, structural issues in China’s political economy – like Soviet Russia’s, Brazil’s, Japan’s, and many others before it – are likely to prevent the smooth unwind of excesses, making it difficult to avoid further increases in indebtedness and a longer-term deceleration in growth.

The week ahead is largely bereft of major US data releases. Friday’s durable goods report looks like the only hard data with the potential to move markets, but a flurry of Fed speakers will help keep traders on their toes: Bostic and Barr will appear on Monday, Barkin, Barr, Bostic, and Williams will follow on Tuesday, Goolsbee will hit the mic ahead of the release of May’s meeting minutes on Wednesday, and Waller is scheduled to give a keynote address on Friday.

Global developments should prove more interesting. Mexico will deliver March retail sales on Monday, followed by May meeting minutes from the central bank on Thursday, helping shed light on whether the first quarter’s softness in gross domestic product could translate into a more aggressive easing posture in the months to come – we think it will, given that officials appointed by President Andres Manuel Lopez Obrador appear to be voting in a dovish bloc. Canada is expected to report a modest slowing in consumer price inflation on Tuesday and an outright decline in retail sales on Friday as labour markets soften and aggregate demand slows. And a raft of purchasing manager indices should help clarify whether recent signs of an upturn in global growth will gain momentum in the months ahead, helping narrow still-wide rate differentials.

Euro Crisis Flashbacks Hit Markets
European political nerves
Market Calm Returns
US inflation vs the Fed
Fed Signals One Cut in 2024, Down From Three
US Inflation Decelerates Sharply, Bolstering Rate Cut Odds

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