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Soft Landing Hopes Drive Dollar Lower

Global stock markets are holding near record highs, Treasury yields are lower across the curve, and the dollar is in retreat as investors bring forward expectations for policy easing from the Federal Reserve. Data out yesterday morning showed core consumer prices advanced at the slowest annual rate in three years last month, while underlying retail sales shrank, suggesting that the world’s largest economy is losing momentum in the face of still-restrictive interest rates.

The core consumer price index climbed 3.6 percent in April from a year ago, marking the weakest pace since April 2021, and “control group” retail sales slumped -0.3 percent month-over-month as households followed sentiment surveys in turning slightly more cautious. The data relieved market participants who had been braced for yet another upside surprise, and triggered a wholesale adjustment in rate projections across a range of asset classes. Two- and ten-year Treasury yields are inching higher this morning after dropping by more than 8 basis points each, and swap markets are showing two rate cuts fully priced in this year, up from the single move that had been expected ahead of the release.

The greenback is following rate cut expectations lower, and all of its major rivals are advancing on a narrowing in growth and rate differentials. The pound and euro are holding firm ahead of a US jobless claims report that is expected to illustrate a further, almost-imperceptible deterioration in labour market conditions. Later in the day, the Cleveland Fed’s Loretta Mester and Atlanta’s Raphael Bostic will discuss the economic outlook in separate events, with both likely to warn investors against reading too much into a single month’s data. Investors will, of course, ignore this.

The Japanese yen is trading near the 154 handle against the dollar, up markedly from the 156 threshold reached in Tuesday’s session. Last night’s disappointing first quarter gross domestic product report – which showed the economy shrinking at an annualised 2-percent pace – has thus far failed to dent optimism surrounding the prospect of rate hikes from the Bank of Japan, but we suspect wide rate differentials will limit upward moves in the currency.

Chinese share prices are advancing, but the renminbi is lagging its major peers as authorities keep a tight rein on the exchange rate. The People’s Bank of China set the midpoint for its reference rate at 7.1020 to the dollar last night, only slightly stronger than the 7.1049 level set in the previous session, effectively restraining the currency’s gains – especially in comparison with other Asian units.

With a thin data calendar ahead, Wall Street’s “fear gauge” – the VIX volatility index – is trading near the lows reached in December, and just above levels that prevailed just ahead of the pandemic’s onset in January 2020. You can almost literally hear Goldilocks snoring.

Conditions are nearly perfect for dollar underperformance. Under Stephen Jen’s “dollar smile” theory, the greenback tends to outperform when money pours into the US during periods of extreme American outperformance or global financial stress, but flounders when expected global growth differentials narrow and flows are redirected into riskier but better-performing assets in other countries

But Canadian dollar bulls should be careful in what they wish for. As long as the Fed is expected to ease because it can (because inflation is receding), the loonie should be positioned for gains – lower borrowing costs should ease the strain on Canada’s over-leveraged economy, and rising market prices will lift investor appetite for the country’s assets. If, however, the Fed is forced to cut rates in the face of a recession or a market downturn, the implications for Canada’s economy will quickly turn negative, pulling the currency lower. A correlation analysis illustrates this: the S&P 500 index long ago supplanted oil prices in driving daily exchange rate movements, and the 10-year Treasury yield has established a clear negative relationship, with higher US borrowing costs translating directly into loonie weakness. As always, if the US sniffles, Canada will get COVID.

Market Retreat Continues as Yields Climb
Hawkish Kashkari Comments Pour Cold Water on Markets
Market Momentum Fades After US Long Weekend
No news is good news
Dollar Cruises Toward Weekly Gain on Fading Easing Expectations
Twists & turns

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