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Liquidity Dissipates Ahead of US Holiday

It’s a little weird out there this morning: Ahead of the North American open, futures on the S&P 500 and Nasdaq are pointing to further gains after both indices hit record closing highs in yesterday’s session, and investors are positioning for a rebound in US retail sales volumes, along with an increase in uncertainty levels as a series of Federal Reserve officials make public appearances before tomorrow’s holiday market closure. Amid thin liquidity conditions, Treasury yields are inching higher, the dollar is advancing, and most major currency pairs are oscillating within narrow trading ranges as participants move to the sidelines.

Market concerns about a right-wing victory in the French legislative election appear to be fading somewhat, helping the common currency regain its footing relative to the dollar and pound. Political risk premia remain elevated, but with National Rally leader Marine le Pen following in her Italian counterpart Georgia Meloni’s footsteps in making moderate noises, investors are moving back toward betting on a “boiling frog” dynamic in which European fiscal imbalances worsen at gradual pace. French-German yield spreads have steadied, and the euro is creeping higher off the weekend’s lows.

More broadly, political instability at the core of the euro area isn’t translating into ructions in wider markets, US equity valuations remain spectacularly high, and the central bank “divergence” trade that animated sell-side notes in recent months simply isn’t panning out. Implied Group of Seven currency volatility – a measure of expected swings in the future – is holding well below historical norms.

The Australian dollar is stuck in a holding pattern after the central bank last night left rates at a 12-year high and warned of “persistent” and “above target” inflation risks. The Reserve Bank of Australia said it wasn’t “ruling anything in or out” and Governor Michele Bullock acknowledged the possibility of further tightening, saying: “While recent data have been mixed, they have reinforced the need to remain vigilant to upside risks to inflation”. Broadly speaking, the Australian economy has been showing signs of slowing momentum – first-quarter gross domestic product was weak, and businesses and consumers appear to be cutting spending as rates remain elevated – but inflation has proven sticky, forcing officials to maintain a “high for long” policy stance, in contrast with their peers in Europe and Canada. Markets are now assigning less than 40-percent odds to a rate cut by year end.

Mexico’s peso is slowly climbing off the floor, inching higher against a stubbornly-strong dollar as volatility expectations subside following the election shock in early June. Markets remain sensitive to constitutional reform comments from sitting president Andrés Manuel López Obrador and his incoming replacement Claudia Sheinbaum, but underlying fundamentals remain strong and the huge differential between expected US and Mexican policy rates at the one-year time horizon has widened in the last week as outflow risks have risen. We think carry traders will be back, albeit in diminished numbers.

The loonie remains rangebound, languishing near the bottom of its recent trading range as persistently-wide rate differentials offset upward pressure from oil prices. Two- and ten-year government bond yield spreads are hovering near 85 and 93 basis points respectively, limiting any positive impact from this morning’s break above the $80 threshold in West Texas Intermediate benchmark. As discussed previously, absolute US Treasury yields, yield spreads, and S&P 500 index levels have become far more important than the crude price in driving the Canadian dollar, reflecting its evolving role as a risk proxy.

Friday’s Commitment of Traders report triggered our contrarian instincts. Non-commercial bets against the loonie climbed to $9.4 billion in the week ended last Tuesday, marking the largest speculative short against the Canadian dollar on record, and suggesting – to us at least – that the risk-to-reward ratio is becoming skewed. The differential between market-implied policy rates for the Bank of Canada and Fed certainly could widen beyond the 80 basis points currently priced in across the three-year curve, but room for such a move looks likely fairly limited, and the risk of a short-covering squeeze – perhaps prompted by a change in the US policy outlook – is growing.

This morning’s US retail sales report is expected to show consumer spending volumes staging a modest rebound from a weak April. Overall receipts are seen climbing 0.3% in May on rising vehicle purchases after flatlining in the prior month. “Control group” sales – which exclude gas stations, auto dealers, office supplies, and building materials stores – could reverse the previous month’s -0.1% drop with a 0.4% jump. A disappointment could firm odds on a rate cut at the Fed’s September meeting and force an altitude adjustment in the dollar, but that could be coming anyway – officials speaking today include Richmond’s Thomas Barkin, Boston’s Susan Collins, Chicago’s Austan Goolsbee, Governor Adriana Kugler, Dallas’ Lorie Logan, and St. Louis’ Alberto Musalem. We expect policymakers to begin acknowledging signs of slowing economic momentum in upcoming appearances, helping move market focus further away from upside risks to inflation and toward downside exposures in labour markets.

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