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Market Briefing: Volatility falls in the run-up to an eventful week

The dollar is setting up for a third day of losses even as markets prepare for an onslaught of potential volatility catalysts in the week ahead. Economists think the US will report a 7.3-percent rise in headline consumer prices when it drops November’s data on Tuesday – confirming a steady easing in inflation pressures.

The Federal Reserve is expected to announce another half-percentage-point hike on Wednesday, and publish an updated set of policy projections showing a gradual deceleration in coming months. The European Central Bank and Bank of England will probably deliver their own half-point hikes on Thursday. Traders will be glued to their terminals throughout, seeking insight into whether a post-September ebbing in market-implied inflation fears has been mirrored in policy circles.

On a trade-weighted basis, the greenback has fallen almost 9 percent from its peak in September. Relative interest differentials are eroding as the Federal Reserve slows the pace of rate hikes and other central banks continue tightening. Safe haven demand is eroding as the conflict in Ukraine settles into a war of attrition. Energy prices are coming down, removing a key differentiator. And we may be moving past “peak pessimism” in other economies as Japan, the euro area, and United Kingdom begin to best expectations.

Speculative positioning in currency markets has room to move: although long-dollar positions have shrunk over the last two months, bets on the yen, pound, and euro don’t yet reflect a 2023 in which they are expected to outperform. Some investors may be waiting until next week’s events before placing bets on the year to come.

Cross-currency basis swap pricing suggests that year-end funding issues have been largely addressed, meaning that the risk of a sequel to 2019’s dash for dollars is lower.

Correlations between the Canadian dollar and the S&P 500 equity index remain remarkably high. If Federal Reserve policymakers fail to push back against a loosening in financial conditions in next week’s decision and Statement of Economic Projections, a Santa Claus rally could unfold, pushing the loonie up a few cents.

The Bank of Canada’s decision to unleash a half-percentage-point hike at Wednesday’s meeting pushed the yield curve deeper into inversion, while its data-dependent language set the stage for a pause – and even a halt – in its tightening cycle. Markets have priced one additional hike in the first three months of 2023, but cuts are expected to follow in the autumn months as the economy weakens. If this holds, interest differentials could remain tilted against the loonie for at least another year.

Today’s US data releases should shed light on several key aspects of the inflation picture ahead of next week’s Fed decision:

Headline producer prices for November, out at 8:30, are expected to rise 0.2 percent from the prior monthor 7.2 percent year-over-year as weaker global conditions, a strong dollar, and improvements in supply chain conditions exert disinflationary pressure on costs. But strong consumer demand should push core prices higher by around 0.2 percent month-over-month, forcing central bankers to continue tightening policy.

The 5-10 year inflation expectations measure included in the University of Michigan’s consumer sentiment index is seen holding steady at 3 percent, suggesting that price psychology remains relatively stable. Overall economic expectations are likely to soften as prices remain high and the US faces stronger headwinds in the year ahead. Markets expect the index to drop to 56.5 from November’s 56.8.

Wholesale inventories are likely to rise 0.8 percent in October as supplier stockpiling outpaces consumer demand – particularly for durable items like large electronics and appliances. “Bullwhip effects” remain significant across the US and global economies, with inventory data vulnerable to rapid changes in both directions.

Karl Schamotta, Chief Market Strategist

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