Risk-sensitive currencies are staging a broad retreat as losses in stock markets continue. North American equity futures are pointing to a lower open after suffering the biggest selloff in two years during yesterday’s session, with a series of earnings misses intersecting with broader economic dynamics to trigger a headlong rush out of “megacap” names that have been the prime beneficiaries of the artificial intelligence craze. Safe-haven currencies are appreciating, front-end Treasury yields are inching lower, oil prices are down, and the broader commodity complex is coming under renewed selling pressure.
The proximate trigger for the selloff isn’t entirely obvious, but we think two interrelated phenomena are at work:
The cost of borrowing in Japanese yen is rising. After a series of official intervention efforts, a slowing in US inflation, and a big jump in bets on rate hikes from the Bank of Japan, the exchange rate is making a serious attempt at breaking out of its long-term decline. Carry trades funded in yen are growing more expensive, and domestic investors now have an incentive to deploy money at home instead of in hedged dollar-denominated vehicles. An anchor for global capital flows is slowly being lifted, taking the air out of emerging market currencies, US technology stocks, and long-term Treasury markets.

The US yield curve is moving close to dis-inversion, with the difference between ten- and two-year bond yields – which has been negative for the better part of two years – suddenly moving toward positive territory. Short rates are declining as investors grow more confident the Federal Reserve will begin an aggressive easing cycle in September, and long rates are climbing as the prospect of a second Trump administration brings the impact of tighter immigration restrictions, higher tariffs, and greater fiscal expansionism into closer focus. This is raising market fears of an imminent economic downturn, given that the curve has inverted – and then dis-inverted – before all but one of the nine recessions since 1955*.

Volatility expectations are lurching off their seasonal lows. The VIX one-month implied equity volatility index is trading with a 19 handle, up from 12 at the beginning of the month. A similar measure that captures moves in the major currency pairs is nearing a one-month high, and risk reversals are pointing to elevated downside exposure in the units most sensitive to changes in risk appetite and funding costs – including the Australian, New Zealand and Canadian dollars, along with the Brazilian real, Mexican peso and South African rand.
This morning’s data could bolster negative views on the economy. Updated gross domestic product numbers are expected to show output expanding at a 2-percent annualised pace in the second quarter, accelerating slightly relative to the first three months of the year, but slowing momentum in underlying final demand might signal a softer handoff into the second half. The annualised quarter-over-quarter core personal consumption expenditures index – the Fed’s preferred measure of inflation – should come in close to the 2.6 percent mark, leaving tomorrow’s June print close to flat on a month-over-month basis. Continuing jobless claims could continue their grind higher, pointing to a cooling labour market. And ex-defense, ex-aircraft durable goods – a measure of consumer demand – might stage a weak rebound in June after declining in the prior month.
Markets are increasingly confident the Fed will deliver a clear easing signal at next week’s meeting. Fed fund futures are now assigning 115-percent odds to a rate cut at the central bank’s September meeting, meaning that a not-insignificant number of participants expect policymakers to kick things off with a 50-basis point move. We would argue that this level of certainty is negating the need for an earlier jump off the starting block – by allowing markets to ease conditions so aggressively, the Fed is already reducing the level of restrictiveness in the economy – but also understand why officials might feel the need to provide more directional clarity in the near term.
North of the border, the Canadian dollar remains remarkably unchanged after the Bank of Canada paired yesterday’s quarter-point rate cut with a surprisingly dovish set of communications, setting the stage for more policy easing this autumn. Instead of the somewhat-hawkish messaging I had expected,** Governor Macklem said “With the target in sight and more excess supply in the economy, the downside risks are taking on increased weight in our monetary policy deliberations,” it’s “reasonable” to expect further rate cuts because “We need growth to pick up so inflation does not fall too much, even as we get inflation down to target”.
Echoing our own views, officials downplayed risks associated with a potential widening in policy rates relative to the Fed’s settings. Macklem said “With inflation showing more signs of easing in the United States, my sense is that divergence is not going to be particularly serious”. Markets agree: policy rate differentials – which derive expectations for the Fed’s policy rate and the Bank of Canada’s from overnight index swap prices – are holding stable across one, two, and three year time horizons at levels that have essentially prevailed since early April.

*An excellent history of yield curve inversions (written last year) can be found here.
**To be clear, I got this completely wrong – the Bank was far less cautious than I had anticipated, with short shrift given to inflation and housing speculation risks in the statement, Monetary Policy Report, and press conference. I’d eat some humble pie, but I’m an FX strategist – I ran out of it a long time ago.