The dollar is climbing off a nearly one-month low and measures of risk sentiment are improving as traders jostle for position ahead of this morning’s Congressional testimony from Federal Reserve Chair Powell.
Powell is widely expected to adopt a dovish stance, describing a more “balanced” outlook, with downside risks in the labour market beginning to outweigh inflation in driving monetary policy calculations. In prepared comments released ahead of his appearance before the Senate banking committee, the Fed chair is likely to acknowledge signs of slowing momentum in the central bank’s preferred economic indicators, with price growth cooling, consumer spending ebbing, and the unemployment rate grinding higher in recent data releases. He could repeat the message delivered earlier this month in Sintra, Portugal, noting that policy settings are now at “restrictive” levels, making it clear that further rate hikes are exceedingly unlikely, and
But it may be difficult to out-dove the doves. According to the text of the July Monetary Policy Report, released last week, the Fed’s rate-setting committee “does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent,” with two-sided dynamics now in play: “Reducing policy restraint too soon or too much could result in a reversal of the progress on inflation. At the same time, reducing policy restraint too late or too little could unduly weaken economic activity and employment”. In our view, Powell will emphasise the central bank’s data-dependent stance, doing his best to ratify current market pricing – Fed Funds futures are currently placing roughly 70-percent odds on an early-autumn rate cut – without moving the needle dramatically in either direction. Three consumer inflation updates, two personal consumption expenditures releases, and two non-farm payrolls reports – along with a raft of other important data points – will land between now and the September meeting, giving policymakers plenty of time to recalibrate expectations and telegraph a move if necessary.
Like most observers, we expect softening price pressures will give the Fed enough confidence to begin cutting in September, but consensus forecasts ahead of Thursday’s US consumer price index report are making us a little nervous. Month-over-month core inflation estimates published by the top ten money centre banks are pinned within a remarkably tight range, from 0.14 percent on the low end to 0.25 percent on the top – despite consistent volatility in the core services component. Investors could react badly if the print comes in above expectations.
In a rather fascinating turn, there still isn’t any clear evidence of negative market implications arising from the Fed’s hawkish stance. The central bank’s efforts to reduce its balance sheet – paralleled by most of its major counterparts – have thus far left volatility expectations near historical lows, and global asset prices have continued their march higher. For investors, fiscal policy – not monetary policy – remains in the driver’s seat.
The euro is holding steady, with market participants staying cautious after the weekend’s French election brought fiscal risks back into sharp focus for investors in the common currency area. The spread between French and German bond yields has fallen from the levels hit in June, but remains elevated as the prospect of a hung parliament reduces the likelihood of reform in the country’s currently-terrible tax-and-spend policy framework. The debt rating agency Moody’s yesterday said that it may lower France’s sovereign debt outlook in coming months if interest payments continue to rise relative to government revenues and gross domestic product.
The British pound remains on the offensive as traders brace for more guidance from policymakers at the Bank of England. The currency climbed yesterday after outgoing Monetary Policy Committee member Jonathan Haskel – a known hawk – highlighted inflation and wage growth risks, and suggested that he would not vote for a rate cut at the Bank’s August meeting, but tomorrow’s speech from chief economist Huw Pill – a more neutral observer – could see easing expectations ratchet higher. Investors expect next week’s consumer price index release to play a deciding role, and we think stubbornly-elevated services costs could translate into a shift toward pricing a September rate cut.
The Canadian loonie is virtually unchanged relative to Friday’s close as monetary policy expectations on both sides of the 49th Parallel move in relative synchrony. Options pricing is turning modestly more bullish however, suggesting that a dovish message from Jerome Powell this morning could see the currency push higher against the dollar on a sustained basis.
Today’s data calendar looks light, but dollar-supportive political risks are still simmering in the background.
US Republicans are doubling down on threats to raise trade barriers ahead of next week’s national convention. The party yesterday released its 2024 election platform, saying “Our Trade deficit in goods has grown to over $1 Trillion Dollars a year. Republicans will support baseline Tariffs on Foreign made goods, pass the Trump Reciprocal Trade Act, and respond to unfair Trading practices. As Tariffs on Foreign Producers go up, Taxes on American Workers, Families, and Businesses can come down”. Donald Trump had previously threatened to raise tariffs by 60 percent on imports from China, and by 10 percent on all other US imports – thresholds that would reset trade barriers to levels last seen in World War Two.
Beyond making capitalisation rules great again, we suspect that the prospect of renewed protectionism will represent an increasingly material menace to currently-low levels of implied volatility in foreign exchange markets. As dozens of previous attempts have shown – all the way back to the Corn Laws in 1815 or the Smoot Hawley Tariff Act of 1930 – protectionist policies tend to slow global growth rates without addressing the underlying causes of imbalances. In this case, higher barriers could perversely widen the trade deficit (just as they did during the first Trump administration): if the US economy becomes increasingly isolated from global markets, domestic inflation pressures might rise – necessitating tighter policy from the Federal Reserve and driving the dollar higher – while the currencies of exporting countries will fall, making them more competitive in nominal terms. Either way, volatility expectations just seem too low when the prospect of an escalation in the “trade wars” narrative looms.
