Good morning, and happy Halloween.
Currency and government bond markets are holding steady after a week in which monetary and fiscal policymakers largely delivered on expectations: the Bank of Canada raised rates; the Federal Reserve, the European Central Bank and the Bank of Japan all held; and in Britain, Chancellor Healey delivered a well-telegraphed, fiscally moderate Budget that kept investors onside with Andy Burnham’s government. Most major currency pairs look largely range-bound, with measures of expected volatility remaining remarkably subdued – including at the one-week horizon – suggesting that participants expect more of the same over the coming days.
The calm does not extend beyond rates markets, however. Global oil prices remain extremely elevated ahead of a possible American and Israeli strike on Iran, the Nasdaq is flirting with correction territory as scepticism about the artificial intelligence buildout spreads, and growth worries are beginning to displace inflation risks as the dominant driver of price action.
Tuesday’s US midterm elections will dominate the airwaves but are unlikely to spook currency markets. Rising living costs, an unpopular war with Iran, growing concern about graft, and the president’s historically-low approval ratings are all pointing the same way, and the consensus overwhelmingly favours a conclusive Democratic victory. Prediction markets are putting the odds on a sweep of both chambers at 70%, with a 25% chance of a split Congress, and just 5% on Republican control.
The dollar could trade sideways under a “blue wave” outcome. Investors expect greater constraints on fiscal spending and tighter regulation of the technology sector to lower term premia and depress growth expectations, weighing modestly on the dollar. That effect could be amplified if the Treasury announces reduced long-end issuance or larger buyback operations in Wednesday’s quarterly refunding announcement, effectively shortening the maturity profile of the Treasury market. But with neither party showing any willingness to tackle fiscal imbalances, authority over the artificial intelligence buildout largely devolved to the states, the president retaining his veto, and trade and foreign policy remaining under executive control, a decisive pivot in America’s economic trajectory looks unlikely. The growth and inflation differentials that drive exchange rates should remain materially unchanged.
However, this week’s upsets in Brazil and Israel are a reminder that today’s political landscape remains turbulent and deeply unpredictable*. A Republican upset would lift the growth and inflation outlook and push yields higher, encouraging investors to double down on the “US exceptionalism” trade, while an inconclusive outcome – with contested results ushering in a period of uncertainty – could test the dollar’s safe-haven appeal and lift the yen and Swiss franc.
The bigger impact may come from a decisive move to end the war with Iran. If the outcome clears the way for the US and Israel to launch a new, overwhelming attack – and to then declare victory** – the calculus underpinning global energy markets and broader risk sentiment could shift dramatically, driving a wave of adjustments in expected monetary policy paths, interest rates, and exchange rates.
The pound is trading near a six-week high against the dollar and an 18-month high against the euro as markets fully price in a quarter-point hike from the Bank of England on Thursday, followed by three more next year, well above expectations for the Fed and ECB. The balance of inflation risks has tilted to the upside in recent months as energy prices have climbed, and we think that upgraded forecasts could persuade seven of the bank’s nine policymakers to vote for an insurance hike now, while laying the groundwork for another move in early 2027. That should lend the pound some support. However, hints of conditionality could pull in the opposite direction. Should officials suggest that an absence of second-round effects would ease the pressure to tighten, expectations could move closer to our own view, in which the bank ultimately delivers fewer hikes than are now priced in.
Mexico’s central bank is expected to hold its benchmark rate at 6.50% on Thursday for a fourth consecutive meeting, even as climbing energy prices and a depreciating peso add to inflation pressures. A slight hawkish tilt is possible: core and headline inflation are running near the top of Banxico’s tolerance band, and policymakers introduced some conditionality in last month’s statement, saying future decisions would depend on a “continuation of the disinflationary process”. But there has been no sharp jump in price expectations, borrowing costs are close to estimates of neutral, and the economy is operating with significant slack, making it appropriate to keep rates on hold for now. In contrast with past cycles, officials say Mexico’s greater economic stability means they need not “react mechanically” to Fed moves — so rate differentials could continue to narrow against the peso.
Job numbers on both sides of the border on Friday could – on the margins – drive an adjustment in rate expectations. The consensus expects US non-farm payrolls to rise by 55,000 after September’s weak 29,000 gain, with unemployment holding at 4.2% and average hourly earnings up 0.3%. Canada is seen adding 15,000 jobs after shedding 110,000 over the previous two months, with the jobless rate holding steady at 6.5%. Downside risks are clear, but there are also good reasons to brace for upside surprises: an unusually-early flu season in the US could lift healthcare hiring, and last month’s clear aberration in Quebec’s public-sector employment numbers is due for correction. With investors placing 70% odds on a December rate hike from the Fed and coin-toss odds on a similar move from the Bank of Canada, there is room for a recalibration in rate curves – markets abhor uncertainty and tend to resolve it by seizing on new narratives, whether justified or not.
The week ahead will be dominated by the midterms, but is littered with other potential catalysts and may ultimately be remembered for what happens far from the ballot box.
*Prediction markets and polls have hardly covered themselves in glory.
**Symbolic or otherwise.
***Note that Mark Carney’s government will deliver a federal budget on Thursday, but Canadian budgets rarely move currency markets, and this one is unlikely to prove an exception given that most major spending initiatives have already been aired. Investors could take notice if substantive tax reforms are tabled, however — and we will be watching for precisely that.