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Rebalancing Flows Drive Mixed Currency Outcomes

Month- and quarter-end rebalancing flows are driving the dollar down against most of its major counterparts this morning, providing a modicum of relief across a range of asset classes. S&P 500 and Nasdaq futures are edging higher after tumbling yesterday on a rotation out of technology sector stocks, Treasury yields are up almost imperceptibly, and the commodity complex is experiencing a mild bout of mean reversion.

The Mexican peso is grinding higher after carry traders piled back in during yesterday’s session, seizing on wide rate differentials and falling volatility expectations to drive the exchange rate to a circa-1.4-percent gain. Investors remain sceptical of the Sheinbaum administration’s reform plans, but last week’s naming of a relatively centrist and technocratic cabinet has helped assuage fears of a sharp deterioration in the business climate. We think the Banxico will stay on hold in Thursday’s meeting, with stubbornly-persistent inflation pressures, the peso’s sharp depreciation, and uncertainty surrounding the autumn US election helping make the case for a prolonged plateau in carry trade-supportive rates.

Japan’s yen is coming under renewed selling pressure on bets authorities will permit a fall through the 160 threshold against the dollar. With investors exhibiting less demand for safe havens and rate differentials remaining gapingly wide, the currency has steadily depreciated for days, and options markets are pointing to further downside ahead – even if the Bank of Japan delivers a bigger-than-expected quantitative tightening package at its next meeting.

Markets are growing more comfortable with the range of outcomes possible in the French election beginning this weekend. The euro is down roughly 1.6 percent against the dollar relative to the level prevailing ahead of President Macron’s call, but losses appear to be diminishing, with investors aligning around a base case scenario in which the right-wing National Rally party fails to win an absolute majority and is forced to work with a coalition of other parties, limiting the impact of any fiscal changes. We suspect the euro will ultimately emerge broadly unscathed, but market positioning nonetheless looks uncomfortably reminiscent of the situation prevailing ahead of Mexico’s election in early June, suggesting – to us, at least – that tail risk hedges should be put in place to guard against an unexpected outcome.

The Canadian dollar is trading near a three-week high after the Edmonton Oilers failed to capture the Stanley Cup, and ahead of data that is expected to show the central bank’s preferred inflation measures continuing their steady moderation. Markets are assigning circa-60-percent odds to a move at the Bank of Canada’s July meeting, with a total of four cuts seen coming over the next year – but this roughly matches the number expected from the Federal Reserve as investors prepare for a quarterly cutting cadence at both central banks (note that the Fed will be cutting from a higher base).

History’s biggest bet against the loonie isn’t paying off: According to the Commodity Futures Trading Commission’s latest Commitment of Traders report, released yesterday, non-commercial short positions against the currency edged higher to $10.8 billion US dollars as of last Tuesday, marking a second week in record territory and pointing to sharp losses for speculators. We don’t expect huge gains to unfold over the coming months, but also believe that the “central bank divergence” story was always too simplistic to survive contact with reality. As a debt-afflicted proxy for global risk appetite, the Canadian dollar’s biggest vulnerability is still likely centred in US financial markets, where volatility expectations remain too low.

This week’s data should help quantify the strength of the US household spending handoff into the third quarter. Consensus forecasts – bolstered by last week’s weaker-than-anticipated retail sales numbers – suggest that today’s Conference Board’s index will show consumer confidence dropping in June relative to May. Thursday’s durable goods orders report could see purchases of big-ticket items declining month-over-month in May, reversing gains from the prior two months. Friday’s personal spending and income data should bring modest gains, while the core personal consumption expenditures index – the Fed’s preferred measure of inflation – is expected to print near the 2.6-percent level, marking its smallest year-over-year gain since early 2021.

The odds on a Fed “mistake” are rising: If the year-over-year change in the core personal consumption expenditures index matches expectations, the gap between the lower bound of the Federal Funds rate and the level of underlying inflation will be at its widest since September 2007 – hardly an auspicious sign for the growth outlook. Taken in combination with the steady rise in jobless claims in recent weeks, we expect policymakers to begin highlighting downside risks more forcefully in upcoming appearances, helping prepare markets for a live meeting in September.

Labour market developments look likely to take precedence over inflation in influencing Fed policy over the coming months*. A slew of indicators are pointing to a cooling in job creation rates, business investment is slowing, and consumer confidence in the labour market appears to be falling, suggesting that unemployment rates could grind higher into the early autumn. In a speech yesterday, the San Francisco Fed’s Mary Daly warned “future labour market slowing could translate into higher unemployment, as firms need to adjust not just vacancies but actual jobs,” saying “…inflation is not the only risk we face. We will need to keep our eyes on both sides of our mandate—inflation and full employment—as we work to achieve our goals”.

*This comes with a generous helping of humble pie: we held almost exactly the same view on January 1, only to see inflation drive the bus for another six months.

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