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Markets turn negative as threat environment worsens

Markets are back on the warpath this morning, pushing Treasury yields and the dollar toward cyclical peaks. The US ten-year is holding near 16-year highs, the trade-weighted greenback is at its strongest levels in six months, risk-sensitive currencies are retreating, and global oil benchmarks keep pushing toward the $100 per barrel mark.

Two major factors are bolstering the US exceptionalism trade: strong domestic demand numbers are forcing investors to capitulate in the face of the Federal Reserve’s higher-for-longer mantra, and risk-reward ratios in other currencies are worsening as soaring oil prices threaten to raise costs in the major energy importing regions. And the beatings could continue: data from last Tuesday showed the net-long speculative dollar position flipping into positive territory for the first time since last November, while bullish bets on West Texas Intermediate rose to the highest since February 2022.

The euro is trading on a modestly-stronger footing, but last week’s losses remain largely unrecovered. The German Ifo institute’s measure of business expectations moved up to 82.9 in September from 82.7 in the prior month – a modest improvement, but one that certainly doesn’t paint an optimistic picture of underlying fundamentals, particularly after last week’s appallingly-weak purchasing manager indices.

Japan’s yen is gradually inching toward the 150 mark against the dollar, but is stuck within a narrow daily trading range as traders and speculators watch for signs of intervention. Government officials have stepped up jawboning efforts over the last month, but Governor Kazuo Ueda’s refusal to deliver anything resembling hawkish guidance at last week’s Bank of Japan meeting has renewed downward pressure on the exchange rate.

Chinese markets are seeing renewed outflows as the property sector keeps deteriorating. Both the onshore and offshore yuan exchange rates are holding beyond the 7.30 threshold against the dollar as the stocks of real estate firms plummet amid fears of a liquidation at the world’s most indebted developer, China Evergrande Group.

The US government is hurtling closer to a shutdown. House Speaker Kevin McCarthy is struggling to gain support for a short-term funding deal – or continuing resolution – that would buy time for further negotiation, facing strident opposition from the hard-right House Freedom Caucus and from former president Trump, who on the weekend posted a social media message suggesting that a shutdown could represent “the last chance to defund these prosecutions against me and other Patriots”. 

In recent decades, shutdowns have failed in achieving their aims, with popular opinion turning against the Republicans within days, even as key concessions remained unextracted. But this one – coming as the United Auto Workers strike ramps up, oil prices climb, and student loan repayments resume – could prove more painful for the economy.

We think this backdrop implies yields will follow historical patterns in falling as the funding deadline approaches – reflecting increased safe-haven demand and lowered expectations for Fed policy – with the dollar catching a bid. Markets could behave differently as long as inflation remains sticky and monetary policymakers retain a hawkish bias, but we don’t think markets have yet begun to question the creditworthiness of the United States itself – although an emerging markets-style rise in interest rates could be associated with future shutdowns if the political system continues its descent into dysfunction.

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