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Volatility creeps higher with US yields, keeping safe havens bid

Financial markets are facing headwinds this morning from higher interest rates and a slowing Chinese economy.

Equity futures are setting up for a lower open, US Treasury yields are inching lower after again challenging multi-decade highs during yesterday’s session, and commodity prices are trading sideways as markets simultaneously downgrade Chinese demand forecasts and raise stimulus expectations.

Foreign exchange markets are trading on a mixed footing, with risk-sensitive currencies fighting an increase in implied volatility expectations – partly seasonal, partly rates-driven, and partly China-related – even as domestic yields play catch up with the United States

North America

Expectations are rising ahead of Jerome Powell’s appearance at next week’s annual economic symposium in Jackson Hole, Wyoming.
Markets expect him to respond to a series of stronger-than-expected data releases with an overtly-hawkish higher-for-longer message on interest rates. Alternatively, he could choose to focus on the conference’s theme – “Structural Shifts in the Global Economy” – by downplaying the changes that have occurred over the last few years and joining his colleague John Williams in suggesting that neutral rates could soon fall (albeit not all the way back to pre-pandemic averages).

Jackson Hole’s impact on markets has historically been rather binary. A number of speeches in recent decades – Rajan in 2004, Bernanke in 2007 and 2010, Draghi in 2014, Powell in 2020 and 2022 – have put the foundations in place for world-shaking shifts in monetary policy and big changes in interest rates. Other, largely theoretical diatribes have landed with all the sound and fury of a wet paper towel. We suspect this year’s event will look more like the latter (and will nonetheless be glued to the Fed’s website at 10:05 am next Friday).

But an unremitting string of growth surprises – and a flood of Treasury issuance – could be bringing policymakers closer to achieving their goals. With curves steepening violently and ten-year yields pushing toward multi-decade highs even as inflation expectations remain well-anchored, financial conditions in the real economy are finally moving into restrictive territory, crushing cheap money-fuelled business models, weighing on long-duration tech stocks and lifting mortgage rates toward post-global financial crisis peaks. The Fed may be content to let this play out.

Key interest rates, %

There are no major data releases scheduled for the North American session today, and the Canadian dollar is trading on a consolidative footing, reacting to changes in global risk appetite and commodity prices more than domestic drivers. From a technical perspective, the exchange rate looks hemmed in between 1.3450 – the 200-day moving average and 1.3580 – the loonie’s early-June low. On a longer-term basis, we’re increasingly skeptical the Canadian economy will prove able to weather the rise in global borrowing costs that is currently unfolding, and now expect strain to emerge in a more profound way within months. Gains could prove relatively short-lived.


The euro is clinging to the 1.09 level against the dollar as expectations for European Central Bank rate hikes become less focused on the September meeting. Current pricing suggests traders are assigning coin-toss odds to a move before October after several of the most influential hawks on the Governing Council turned more cautious in recent weeks, and there is only one hike priced in before year end – marking a sharp downgrade from the overly-bullish expectations that prevailed less than a month ago. But – given lower terminal rate expectations – markets remain convinced Europe’s monetary policy mandarins will ultimately cut rates more infrequently and at a smaller scale than their American counterparts, and swap pricing continues to suggest a narrowing in rate differentials farther out on the curve.

Monthly EURUSD forward differential by tenor, points

The pound is marginally weaker after retail sales dropped more than anticipated. Receipts including fuel fell 1.2 percent month over month in July, with “core” sales down 1.4 percent – but with data releases earlier in the week pointing to continued strength in wage and price pressures, expectations for the Bank of England’s tightening trajectory remain relatively unmoved.

Asia Pacific

The Chinese yuan is stuck firmly below the 7.30 mark after the People’s Bank of China set the daily reference rate at 7.2006 to the dollar last night, signalling stronger commitment to intervening on the currency’s behalf. According to Bloomberg reporting yesterday, authorities have instructed state-owned banks to sell foreign currencies against the yuan as they attempt to prevent wider capital outflows and a worsening in investor sentiment.

In theory, these efforts could widen rate differentials against the yuan – as Chinese institutions divest themselves of Treasuries, US yields should rise relative to China’s. But institutional buying was largely concentrated in agency bonds and equities over the last five years – a period during which Chinese authorities conducted a kind of “stealth intervention” to smooth volatility and restrain the yuan’s gains. We suspect the impact on the US rates landscape could be more minimal than feared, subtracting from overall liquidity while exerting less influence on the Treasury market.

The Japanese yen continues to tread water near the 145 mark against the dollar as intervention worries, evidence of sustained price pressures, and a modest retracement in US yields generate conflicting cross currents. Core inflation – which in Japan excludes fresh food, but includes energy – slowed to 3.1 percent year-over-year in July, down from 3.3 percent in the prior month. The so-called “core-core” measure, which serves as a closer analogue to the core measure used in other advanced economies, accelerated to 4.3 percent from 4.2 in the previous month. Services costs rose 2 percent, up from 1.6 percent as inflation pressures became more embedded in the underlying economy.

We remain unconvinced by recent price action in the yen, and think the currency has room to outperform later in the year. Relative rate differentials might shift as cuts are more firmly priced into US expectations for 2024, trade surpluses should grow on a solid export picture and stabilizing commodity prices, and demand for yen-funded carry trades should evaporate as emerging market central banks begin loosening policy.

Market Retreat Continues as Yields Climb
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Twists & turns

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