Markets are turning defensive ahead of the weekend as the war in the Middle East shows little sign of progress and investors grow more cautious on artificial-intelligence stocks. Brent and West Texas Intermediate crude look set to post their first weekly gains in three weeks after Hezbollah rejected a new ceasefire in Lebanon and Israel said it would maintain its troop presence in the country, undermining President Trump’s efforts to negotiate a face-saving exit from the conflict with Tehran. Equity futures are pointing to losses at the open after Broadcom, the semiconductor developer, beat quarterly earnings expectations but forecast disappointing sales growth for its artificial intelligence chips—a combination that is casting a shadow over the broader technology trade, while weighing on broader risk appetite.

The Japanese yen is again testing the 160-per-dollar threshold that has triggered intervention in the past, prompting Finance Minister Satsuki Katayama to warn that authorities are ready to take “decisive action” against excessive volatility. The Bank of Japan is widely expected to raise interest rates later this month—a war-related energy shock is lifting import prices, and measures of wage growth are climbing—with swap markets pricing in a second hike by year-end. But the gap with US rates remains vast, and until it narrows meaningfully, the yen will struggle to find a floor.

The dollar has been the clear outperformer on foreign-exchange markets this week, climbing roughly 0.4% against a basket of major trading partners. After a brief dip last month, the currency is once again winning the cleanest-dirty-shirt contest, gaining against the euro, pound and yen, all of which are negatively exposed to higher energy import costs, while drawing additional support from signs of reacceleration in the American economy itself. Economic surprise indices have hit three-year highs as jobs, consumer spending and business-activity data have beaten forecasts, and a revival in the artificial-intelligence boom has reanimated capital flows into US markets.

Investors are positioned for a strong payrolls report in less than an hour. Consensus forecasts point to a modest 85,000-job gain in May, but the whisper number—the informal estimate circulating on trading desks—is likely closer to 100,000 after several weeks of better-than-expected labour-market data. An in-line print may leave markets unmoved, but an upside surprise could see traders fully price in a Federal Reserve rate hike this year, while a disappointment would risk a sharp unwind in yields and the dollar.

The opposite dynamic is in play north of the border, where traders are braced for another weak jobs release. Economists think the Canadian economy added roughly 10,000 positions in May, with the unemployment rate holding at 6.9%—but after a string of disappointments, no one would be shocked by a softer print*. The loonie looks technically oversold, yet remains susceptible to a retest of its year-to-date low around 1.3967 if the two reports result in a further widening in interest rate differentials.

Next week will bring three key releases for currency markets:

Wednesday’s US consumer price index update will bring binary risks for the dollar. Headline prices are set for another sharp gain in May, with consensus forecasting a 0.4% monthly rise and a year-on-year rate of 4.1%, up from 3.8%. The core measure—more relevant from a monetary-policy standpoint—should look more subdued, edging up to 2.9% year on year from 2.8% as households turn more cautious and lagging measures of shelter costs continue to weigh on the calculation. Signs of a peak in price pressures, particularly if preceded by a disappointing payrolls report, could see markets pivot back toward expecting a rate cut from the Federal Reserve this year, weakening Treasury yields and the dollar. Evidence that inflation is broadening would have the opposite effect, lifting short-term yields and reinforcing the case for further tightening.

The Bank of Canada is expected to leave its benchmark rate unchanged later on Wednesday, extending a pause that began late last year as it balances downside economic risks against renewed inflation from the Middle East oil shock. Talk of a “technical recession” probably overstates its severity, but the economy is undeniably in a downturn: labour markets are softening, consumer spending is faltering, and business investment remains extraordinarily weak. This is producing a split in the inflation data: while headline prices bear the clear imprint of higher energy costs, the core measures the Bank tends to target are showing little sign of overheating**. We expect the Governing Council to stand pat and wait until after July’s full Monetary Policy Report—perhaps well after—before signalling any tightening bias. Swap markets continue to price in a hike by year-end, leaving the loonie vulnerable to a repricing in the near term, even as the prospect of a resolution in the Middle East raises the odds of an eventual recovery.

The euro could receive a short-lived boost on Thursday if Christine Lagarde pairs the European Central Bank’s widely expected rate hike with a hawkish outlook, clearly signalling at least one more move to come. Several officials have said the central bank can no longer “look through” the energy-price shock rippling across the global economy, and the staff forecasts presented alongside the decision are likely to show headline and core inflation pressures pointing clearly upward, helping justify a second rate hike by September. But the euro area economy remains conspicuously weak—labour markets, consumer spending and private-sector activity are all softening—and tightening into that weakness is unlikely to provide sustained support for the currency. A peace agreement in the Middle East could realign the calculus, but failing that, we see risks to the common currency tilted to the downside in the near term.

Prevailing dynamics point to further dollar strength, but conviction is low—news of a resolution in the US-Iran conflict could trigger a wholesale reversal at any time. Against such a deeply-unpredictable*** backdrop, treasury teams should consider placing automated orders**** and options strategies designed to capture upside while protecting against a sudden adverse move.

*Arguably, with speculators now sitting on heavy short positions against the loonie, a positive surprise could have the biggest market impact.

**To me, the important distinction is between imported (headline) inflation that central banks are ill-equipped to manage, and domestic demand-led (core) inflation that can be influenced through the raising and lowering of interest rates. Canada, like many other countries outside the US, is seeing these two measures pulling in opposite directions, bolstering the case for staying on hold.

***In this environment, Warren Buffett’s dictum seems relevant: “Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future”.

****Particularly stop losses, which can be placed to protect gains in the event of a reversal.