Market Brief: Calm After the Storm Settles on Currency Markets

Financial markets are enjoying a period of placidity amid a relative lack of new headline risks related to the incoming administration’s trade, immigration, and fiscal policy plans. The global borrowing cost benchmark—the ten-year US Treasury yield—is holding near 4.62 percent, down from last week’s flirtation with the 4.8-percent threshold, equity futures are inching higher, and the dollar is eking out small gains after President Trump generally avoided discussing the economy and stopped short of issuing new tariff threats in a closely-watched interview with Fox News last night.

US labour markets showed signs of stabilising in recent weeks. According to data released this morning, the number of initial applications for unemployment benefits climbed to 223,000 in the week ended January 18, up slightly from the prior week. The number of people continuing to receive benefits jumped to 1,899,000 from 1,853,000 in the prior week however, suggesting that December’s outsized job market gains are fading somewhat as seasonal demand adjustments are made.

Here in Canada, consumers erred on the side of caution ahead of the holidays. An update from Statistics Canada numbers this morning showed core retail sales—which exclude gas stations and auto dealers—tumbling -1.0 percent in November even as overall receipts remained unchanged, with general merchandise retailers and building materials outlets printing negative month-over-month declines. An early estimate suggested that receipts at retailers climbed 1.6 percent over the prior month in December, potentially reflecting an expected boost to spending generated through a government tax holiday, but also possibly swayed by changes in energy prices in the month.

The Bank of Canada is also likely to remain cautious when it meets next week. With economic slack remaining substantial, core inflation measures running well below target, and the threat of a trade war with the United States weighing on business investment and consumer sentiment, policymakers are widely expected to keep nudging the overnight rate toward “neutral”, which is suspected to be somewhere between 2.25 and 3.25 percent. Swap markets are putting 88-percent odds on a rate cut, with one more move priced in before year end - a pace that would slightly widen the country’s policy rate differential relative to the US. This shouldn't, in and of itself, be market-moving, given that traders have expected such a divergence for many months now.

A rate hike is essentially fully priced in ahead of this evening’s Bank of Japan meeting. With wage growth showing signs of acceleration*, business associations reporting evidence of growing “demand driven” inflation, and Bank officials clearly signalling a desire to normalise policy, overnight index swap markets are assigning 96 percent odds to a move and another is expected by year end. This means that movement in the yen will hinge on Governor Ueda’s tone during the post-decision press conference: if he signals an openness to further tightening, the currency might edge higher, while a more gradualist articulation of the need for an extended pause could add to already-strong selling pressure.

There are no other major data releases scheduled between now and Tuesday, leaving market participants to monitor Truth Social and follow newsfeeds for any new developments.

From a broader focal point, markets seem to be handling President Trump's repeated tariff threats with remarkable aplomb. Trading in fixed income, equity, and commodity instruments has been stable. Measures of implied volatility in the currency pairs most exposed to a trade shock have risen off their early-2024 lows but remain well within normal tolerances**, and option skews—which capture expected payoff asymmetries—are not exhibiting signs of strain.

The dollar itself is trading at elevated levels, but this can, to a significant extent, be explained by the repricing in US growth expectations that has occurred over the last six months. The residual currency impact left over after controlling for changes in relative yields, inflation expectations, and growth differentials looks surprisingly small, contributing perhaps less than 1 percent of the rise in the trade-weighted dollar index.

We’re at a bit of a loss to explain this. Perhaps businesses and investors have already taken steps to shelter underlying cashflows against downside risks. This seems improbable, given the scale of potential exposures. It is also possible that high uncertainty levels are paralysing directional position-taking among speculators and hedgers alike. However, as the writers of ‘Mobs, Messiahs and Markets’ put it, “If there is one thing we know about the sentiments of crowds, it is that they change. Today it is greed. Tomorrow it is fear. But rarely is it doubt”. A sudden, market-wide case of indecision seems unlikely.

Instead, it seems that traders simply don’t expect Trump to follow through on his threats, at least not on any meaningful scale. This is our base case as well***. But quiet markets might create their own danger by failing to warn Trump and his advisors of the damage that a new trade war could inflict on the economy. If the president believes that tariffs can be jacked up to post-Smoot Hawley highs without risking an adverse market reaction, he may prove more willing to pull the trigger. In short: today’s lack of volatility could plant the seeds for tomorrow’s violent selloff.

*Please note that US and Japanese wage growth measures are not directly comparable. I selected these series to illustrate underlying trends, not absolute values.

**Z-scores measure how far above the historical mean a given value is. At the moment, all four of our selected volatility measures—the VIX, MOVE, USDMXN, and USDCAD option values—are within 1 standard deviation of their 25-year norms.

***As outlined in previous missives, the US undoubtedly has a lot of leverage, but would not emerge unscathed from a conflict with its biggest trading partners: export revenues, corporate earnings, domestic consumer demand, and inflation expectations could all move in a negative direction within a year of implementation, especially if other countries launch symmetric retaliatory measures. Trump's advisors—Scott Bessent most obviously—are very likely aware of this fact.

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