Market Brief: Dollar's Relentless Advance Continues

Demand for the dollar keeps climbing. With less than two weeks to go before the next Federal Reserve meeting and the US presidential election, global investors are piling into the greenback, cutting wagers on an aggressive easing cycle, and betting that the next administration’s policy mix will inflict serious damage on other major economies while generating higher levels of inflation at home. The DXY dollar index is up almost 4 percent from its late September low, options markets are pointing to a growing appetite for hedges against extreme moves around the polling date, and currencies that have strong trade links with the US - the euro, yen, Chinese yuan, Canadian dollar, and Mexican peso - are all trading with significant risk discounts.

This afternoon’s Beige Book survey - one of Jerome Powell’s favourite sources of anecdotal evidence on the state of the economy - could add to the exchange rate’s underlying momentum. Although some of the Fed’s twelve districts will undoubtedly report activity disruptions related to hurricanes Helene and Milton, a range of other indicators suggest that job market conditions are stabilising, business investment is improving, and overall demand remains strong. The Johnson Redbook measure of same-store retail sales is running well above pre-pandemic averages, emphasising the extent to which consumer behaviour is still failing to match consumer sentiment measures.

The Japanese yen’s decline is still gaining momentum, humbling forecasters who had anticipated a momentous rally to ensue after central bankers pivoted in a more hawkish direction earlier this year. The currency broke through its 200-day moving average last night, with a rise in domestic bond yields largely failing to offset a widening in rate differentials against the dollar. We expect the Ministry of Finance and Bank of Japan to increase their largely-futile jawboning efforts over the coming weeks, but further weakness seems in the cards as long as US yields keep powering higher.

But a peak in the dollar could come into view once early November’s event risks are resolved. The Fed’s gradualist message should be well-incorporated in markets by then - and although markets may be surprised by the election’s outcome, they shouldn’t be shocked*. In contrast with the Brexit referendum and presidential election upset in 2016, betting odds now strongly favour a Trump victory, and the noise level in the financial media has reached astounding levels, suggesting that the number of unprepared investors and unhedged organisations is diminishing quickly**.

The Bank of Canada is set to announce its latest rate decision in a few hours, and investors overwhelmingly expect policymakers to deliver a 50 basis point cut. Inflation - particularly if measured on an ex-shelter basis - has fallen well below the central bank’s target range, outpacing declines in interest rates. Unemployment is steadily pushing higher as job creation fails to keep up with population growth. The economy is underperforming the Bank’s last set of (overly optimistic) forecasts, with private sector demand suffering under an increasingly-heavy debt burden. Officials are likely to acknowledge these areas of weakness in the accompanying Monetary Policy Report, and forecasts for the next year should ratchet lower.

But - and apologies for hammering this theme - we should also note that the risk profile in the Canadian dollar looks dangerously asymmetric. Five of the country’s six biggest banks are betting on an oversized move, and overnight swap markets have 82 basis points in easing priced in before the end of the year, meaning that there isn’t a lot of room for a dovish surprise. Fundamentally, we’re not convinced that Canada should pursue a more aggressive easing campaign than has already been laid out, and if policymakers fail to deliver an outsized cut - or simply express more confidence in the economy’s underpinnings than markets currently expect - the ensuing short squeeze*** in the currency could be unusually violent.

*This may appear to be a distinction without a difference, but could materially impact the extent of the market reaction.

**Hint, hint.

***Although this term might also apply to a relationship with a short king, it also refers to a rally that is driven more by a unwind in short positions against a currency than by a shift in fundamentals. A “short squeeze” happens when short-sellers (traders who bet that a currency will fall) are forced to buy it back in an effort to avoid greater losses.

Economic Calendar