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Euro tumbles on weaker private-sector outlook, rate differentials tilt back toward the dollar

It won’t have the self-aware irony of Oppenheimer or the apocalyptic scenes of the Barbie movie, but the week ahead should provide plenty of entertainment for currency market participants. The Federal Reserve and European Central Bank are each expected to raise rates by a quarter point and the Bank of Japan is seen holding pat, but markets could move dramatically if policymakers deliver consensus-busting guidance on their future intentions.

The dollar is building on last week’s gains relative to its biggest rivals after a raft of European purchasing manager indices provided clear evidence of a profound slowdown, and global yields are coming down as investors anticipate earlier rate cuts in the major rest-of-world trading blocs. Oil prices are sliding after a month-long bull run, and North American stock indices are setting up for a stronger open ahead of this week’s earnings releases from the technology giants.

North America

This week’s main event will be Wednesday’s Federal Reserve decision. The central bank is virtually certain to raise rates by a quarter point while issuing a relatively-hawkish statement, but the focus will be on what Jerome Powell says in the post-decision press conference. He may work to correct assumptions in markets – which currently believe this will mark the last hike in the tightening cycle – or, by expressing a more nuanced outlook, effectively confirm prevailing price levels.

We think Powell will try to steer a course between Scylla and Charybdis (as ever) by highlighting improvements in underlying economic fundamentals while acknowledging a cooling in inflation pressures – a combination of factors that could make a “soft landing” more achievable. At the same time, he seems likely to remind observers that underlying labour markets remain too tight, and that the last “dot plot” summary of economic projections – which was taken as the dust settled after a number of bank collapses – showed several policymakers expecting to raise rates at least once more this year.

On balance, we think this should leave markets expecting another “skip” in September, followed by a prolonged period of inaction, with rate cuts priced in for the second quarter of 2024.

On Thursday, the US will deliver its first gross domestic product estimate for the second quarter, with economists expecting real output growth to slow to 1.7 percent from 2 percent in the first three months of the year. With pandemic-era savings winding down and credit conditions tightening, consumer spending probably softened, but business investment likely strengthened as factory construction ramped up.

Two of the Fed’s preferred inflation indicators will arrive on Friday morning,with both likely to remain too high, even as they deliver evidence of slowing growth. The Employment Cost Index inflation is seen easing from 4.8 to 4.5 percent year-over-year after average hourly earnings and a range of other wage pressure indicators showed signs of deceleration in the second quarter. With personal incomes and spending both expected to climb 0.4 percent in June, the core personal consumption expenditures index might rise 0.2 percent, with year-over-year price increases coming in at 4.2 percent – still well above the central bank’s target.

Canada will print May growth numbers on Friday, with a small rebound expected after a flat April. According to the preliminary estimate released by Statistics Canada, output grew by 0.4 percent in the month as housing markets rebounded, federal government employees ended their strike, and consumers kept spending – but subdued energy prices and wildfire-related disruptions may have eroded the gain. The statistics agency’s guess for June might prove more market-moving however, with most observers expecting softness to re-emerge as labour markets stabilized in the month.

The Canadian economy broadly outperformed expectations through the first half of the year, and rate differentials have narrowed on the prospect of more hikes from the Bank of Canada, but the country’s outsized debt vulnerabilities – and overreliance on residential investment – suggest that headwinds are ahead. The loonie keeps trying to climb higher, but markets remain reluctant to push it through the 1.30 threshold against the dollar in the absence of a more profound slowdown in the US economy and a clear end to the Fed’s tightening cycle.

Europe

The euro plunged this morning after a sharp drop in purchasing manager surveys suggested that the European Central Bank could be hiking into a precipitous slowdown, raising the possibility that officials will fail to deliver a long-expected autumn rate increase and begin loosening policy sooner than previously anticipated. Conditions in the euro area manufacturing sector deteriorated more than forecast in July, and the composite index – which measures factory and services activity – slid further into contraction, falling to 48.9 from 49.9 in the prior month.

This adds to our conviction in the dollar remaining the “cleanest dirty shirt” on the global economic landscape, with the US facing smaller downside risks – to the economy, and to rate expectations – than its global counterparts. We think the euro could struggle to meet still overwhelmingly-bullish consensus forecasts by year end.

Asia Pacific

With the yen and Japanese yields repeatedly pushing higher in recent weeks, it’s clear some market participants expect a policy adjustment at this week’s central bank meeting. The Bank of Japan is likely to nudge its fiscal 2023 forecast for “core core” inflation higher – but with softer Tokyo consumer price index numbers expected to land hours before the decision and price growth beginning to slow on a global basis, there’s no pressing need for a hawkish shift in monetary policy settings. We think Governor Ueda will follow through on the dovish guidance provided in recent months, and don’t expect any changes in the Bank’s yield curve target – which might imply a slight weakening in the yen if broader market conditions support a rebound in carry trade activity.

Perhaps more consequentially for currency markets, reports coming out of China’s politburo meeting are pointing to a somewhat-subdued policy response from authorities as they work to pull the economy out of its deepening deceleration. According to the country’s Xinhua news agency, policymakers intend to focus on prioritizing domestic demand over providing supply-side stimulus, and are planning to reduce restrictions on the property sector while providing remedial support for over-indebted local governments – steps that could help stabilize economic conditions but are unlikely to lead to a repeat of 2009-style dynamics (which lifted global commodity demand and provided a compelling reason to sell the dollar against its emerging market counterparts). Of course, China’s growth rates remain enviable by developed-economy standards, and another round of overinvestment in infrastructure – or a melt-up in property markets – would only bolster worries about long-term economic stability.

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Twists & turns

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