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Market Retreat Continues as Yields Climb

Worries about a higher-for-longer stance from the Federal Reserve are intersecting with extraordinarily-elevated levels of government bond issuance to drive yields higher, bolstering the dollar’s safe-haven appeal. With ten-year yields climbing across the developed economies, but moving even faster in the United States, the greenback is trading near a two-week peak, and investors are rebalancing away from equities, commodities, and risk-sensitive currencies.

After a series of stronger-than-expected data releases and hawkish comments from Fed officials, markets are struggling to choke down heavy volumes of bond supply. In comments yesterday, the Atlanta Fed’s relatively-centrist President Raphael Bostic said “My outlook is that if things go according to what I expect – inflation goes slowly, the labour market slowly and orderly moves back into a weaker stance, but a stable-growth stance – I’m looking at the end of the year, the fourth quarter, as the time where we might actually think about and be prepared to reduce rates”. Long-term demand remains strong, but bid-to-cover ratios, which measure the total dollar amount of bids entered relative to the amount of Treasuries being sold, each recorded some of the lowest levels seen in recent years in yesterday’s 2-and 5-year Treasury auctions, helping propel yields upward.

Japan’s yen is trading close to levels that prompted official intervention in late April and early May. Rate differentials have tilted more starkly against the currency and carry trade-related selling pressure has intensified, but market participants remain unwilling to take big directional positions with the threat of further action from the Bank of Japan looming in the background. We suspect that the exchange rate could continue to drift lower at a measured pace – even potentially pushing through the 160 threshold – in the absence of a big risk-off shock. Recent evidence to the contrary, the yen’s inverse relationship with global risk appetite likely remains intact, meaning that a negative blow to US equity markets or the world economy could easily trigger a violent rebound in the currency.

Ahead, the US will likely revise its second first-quarter gross domestic product estimate lower this morning, suggesting that underlying momentum slowed by more than initially assumed in the early part of the year. Jobless claims might inch higher, pointing to a cooling in labour market conditions. The Fed’s John Williams will speak at an event in New York, followed by Lorie Logan in El Paso, Texas. Tomorrow will deliver a bloc-wide inflation print for the euro area, along with the US core personal consumption expenditures index, and first-quarter gross domestic product numbers for Canada. In each case, previously-released data has helped refine market expectations, reducing the likelihood of surprises – but, as recent months have shown, aberrations in specific categories still carry the potential for shifting policy expectations.

Canada’s gross domestic product release could top forecasts, with April’s preliminary annualised estimate potentially topping 0.8 percent on a modest improvement in labour markets, a rise in consumer spending, and an acceleration in home-buying activity. This is unlikely to derail the Bank of Canada’s summer rate cutting plans – economic slack has clearly increased, while inflation has slowed to well within the target band, and shows no signs of rebounding in sympathy with developments in the United States. Interest rates remain in restrictive territory, particularly when set against an economy that is already running the highest household debt service ratios among Group of Seven countries, with the burden likely to grow as almost half of outstanding mortgages are renewed at higher rates in the next three years.

The Mexican peso is holding near the weaker end of its recent trading range in the run-up to this weekend’s presidential election. Andres Manuel López Obrador’s designated successor – Claudia Sheinbaum – is holding a 21-point lead in the polls, and investors expect her to maintain his market-friendly but somewhat interventionist policy stance if the governing coalition keeps its simple majority in Congress. This isn’t certain though: although Sheinbaum will very likely win the presidency, there is some evidence to suggest that support for her Morena party is beginning to ebb, opening an opportunity for the opposition to restrain executive power, and making an even more peso-positive outcome possible. In any case, the huge returns earned through “carry trading” – borrowing in the low cost yen and lending in the higher-yielding peso – that were earned during AMLO’s reign look unlikely to hit a domestically-erected political wall in the coming months.

Looking farther out, we remain convinced that risks emanating from outside Mexico pose the greatest risk to the peso. Movements in the currency are tightly correlated with shifts in US financial markets, and the economy is highly vulnerable to politically-driven changes in Washington’s trade and immigration policy. If volatility enters its typical seasonal climb in the autumn months (see the chart at the end of yesterday’s missive), just as Biden or Trump – or both – take aim at the country’s role in helping Chinese imports enter the US tariff-free, the exchange rate could come under serious selling pressure.

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