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Euro Crisis Flashbacks Hit Markets

Traders are in sell-first, ask-questions-later mode and the euro is coming under sustained pressure as negative rhetoric surrounding the upcoming French election heats up. The dollar and yen are climbing on safe-haven demand, Treasury yields are inching lower, and North American equity futures are looking subdued ahead of what could evolve into a risk-off day in broader financial markets.

Franco-German bond spreads are blowing out after French finance minister Bruno le Maire warned a victory for left wing parties in the upcoming snap election could see the country exiting the European Union, triggering “economic collapse” and a “guaranteed downgrade” from ratings agencies. The difference between ten-year government bond yields in the two countries – a proxy for the risk investors see in lending to the French sovereign relative to its German equivalent – has almost doubled, reflecting worries surrounding the impact a more expansionary fiscal policy could have on the country’s already-stretched position.

A victory for Emmanuel Macron’s centrist coalition is still the most likely outcome, and true parallels with the euro crisis are difficult to see. But we should note that – much as in the United States – fiscal conservatives are a long-extinct breed, and parties on both ends of the French political spectrum favour increases in spending. This raises the risk of an eventual confrontation with Brussels – and with markets, which do not relish the prospect of another Liz Truss-style debacle in the euro area.

Japan’s yen is coming off the six-week low hit last night when the central bank left interest rates unchanged and unexpectedly deferred a decision on reducing bond purchase volumes. Traders thought the Bank of Japan would keep the benchmark rate between 0.0 and 0.1 percent, but many – including ourselves – believed policymakers would begin cutting asset buying from the current 6-trillion yen per month to levels that would begin shrinking the Bank’s balance sheet. At more than 127 percent of gross domestic product, the Bank of Japan’s asset-to-economic-output ratio remains by far the largest in the developed world. Instead, Governor Ueda said “We will present a concrete plan for long term JGB (Japan government bond) buying operations in July,” and warned markets this could be paired with a rate hike, noting that “it’s possible for us to raise the short-term interest rate and adjust the degree of monetary easing at the same time”.

Near-term inflation expectations are falling in the US. Taken in combination with Wednesday’s consumer price index, yesterday’s softer-than-expected producer price index print has led to a broad-based markdown in estimates for the May core personal consumption expenditures index set for release on June 28. The consensus is now pointing to a month-over-month increase in the Fed’s preferred inflation indicator nearing the 0.1-percent threshold, meaning that underlying prices might have risen just 2.6 percent relative to last year’s level – well within the central bank’s target range, and consistent with canonical rule-driven rate cuts.

We suspect that the dollar would be falling if it were not winning the cleanest-dirty-shirt contest. Consumer spending is clearly softening, labour markets are cooling, and economic surprise indices are holding in negative territory – but with countries like Canada and the UK struggling to overcome rate sensitivities, the euro area stuck in a deepening political morass, and Japan running a persistently-loose monetary policy framework, demand for the greenback remains strong on both ends of the risk-reward spectrum.

Putting European political newsflow aside, today’s economic agenda looks quiet, with the US releasing May import prices and the latest University of Michigan consumer sentiment survey. Fed officials including Mester, Goolsbee, and Cook will speak, with markets examining their words closely for clarification on whether Wednesday’s “dot plot” summary of economic projections should be considered stale in light of the week’s softer-than-expected inflation data.

Next week’s data cadence will slow considerably, but should keep traders on their toes nonetheless. The Australian central bank is expected to stand pat on Tuesday, responding to April’s hot inflation print with a relatively hawkish statement. The US and Canada will deliver retail sales numbers on Wednesday and Friday respectively, providing insight into how consumer spending – the most important driving force in both economies – is evolving. And in the United Kingdom, Wednesday’s consumer inflation print and Thursday’s Bank of England decision will set the tone for the pound.

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