Market Brief: Geopolitical Risks Roil Markets, Loonie Rises on Hot Inflation

Correction notice: This morning's Canadian inflation print was for October, not September, and the period described in the debt service ratio chart below should be Q1 1999 to Q1 2024, not November 2022. Sorry for the errors!

Global financial markets are in safety-seeking mode after Ukraine reportedly launched its first long-range missile strike against Russian territory using American-made systems, and Vladimir Putin signed an updated strategic doctrine that would allow Russian forces to deploy atomic weapons in response to a conventional assault from countries backed by other nuclear powers. Ten-year Treasury yields are retreating, North American equity futures are setting up for a drop at the open, and currency markets are displaying classic flight-to-safety characteristics, with the Swiss franc and Japanese yen outperforming their brethren.

Like most geopolitical shocks, this should prove short-lived. Investors expect Putin’s sabre-rattling to die down once a more friendly administration occupies the White House, and the typical vector for geopolitical economic contagion - energy markets - look well supplied at the moment.

The Canadian dollar is powering upward through the 1.40 threshold after inflation accelerated by more than expected last month, lowering market-implied odds on an outsized rate cut at December's Bank of Canada meeting. Data released by Statistics Canada this morning showed the all-items Consumer Price Index accelerating to 2 percent on a year-over-year basis in September October, up from the 1.6-percent increase recorded in September and slightly above consensus expectations that had been set closer to 1.9 percent. On a month-over-month basis, prices rose 0.4 percent, and core inflation, computed as the average of the two price measures now preferred by the Bank of Canada (trim and median), increased 2.55 percent over the same period last year, up from 2.35 in the prior month.

We think the Bank will ultimately favour a smaller quarter-point move, and expect signs of economic resilience to put a floor under policy expectations into 2025. But underlying price pressures are still receding, and if the gross domestic product release on November 29 and the jobs number on December 6 both contradict today’s report in coming in on the softer end of the spectrum, policymakers could move more aggressively to narrow the gap between prevailing rates and the so-called “neutral rate,” which is believed to be somewhere between 2.75 and 3.25 percent.

Against this backdrop, it should be noted that the loonie’s recent losses can be isolated to its relationship with the greenback, not to other currencies. Although it has broken through several symbolic levels to the downside, the exchange rate has outperformed most of its major rivals since the early-November US election.

But this comes after a longer period of underperformance. Although many reasons have been mooted - like declining commodity prices, weak productivity, and trade threats from the incoming US administration - we think the root cause remains squarely centred on household indebtedness, which is substantially higher in Canada than in its Group of Seven peers. Debt service ratios - which measure the share of household disposable income devoted to making required interest and principal payments - are running at more than twice equivalent US levels, exerting serious drag on other spending categories, lowering inflation pressures, and forcing the Bank of Canada to cut rates at an aggressive pace. Donald Trump may pose a threat to the country’s export volumes, but Canada’s decades-long reliance on real estate and debt-fuelled consumption deserves much of the blame for the loonie’s current weakness.

The euro is edging closer to the 1.05 threshold in interbank markets, with a breakthrough likely to open up a move down to 1.03 or lower. Currency forecasters have turned overwhelmingly bearish on the euro as interest rate differentials, growth concerns, and still-present geopolitical risks have darkened the outlook, with some of the world’s largest banks arguing that the exchange rate will fall toward parity - and hold there - over the next year.

An overshoot certainly seems possible. Momentum trades often dominate currency markets. But the scale of the bloc’s current account surplus - €425 billion, or 2.8 percent of gross domestic product in the 12 months ended in September - should give long-term bears some pause, given that it represents a vast flow of surplus savings into other countries and offshore jurisdictions. It’s never wise to discount the tendency of European leaders to miss an opportunity to miss an opportunity, but if politicians were to seize upon Donald Trump’s recent victory as a reason for increasing investment in defence and infrastructure, while beginning to follow the recommendations set out in former European Central Bank president Mario Draghi’s recent competitiveness report, a greater share of savings could be deployed domestically, boosting growth against current expectations.

And it is clear that markets themselves are taking a more nuanced view: although a distribution of probabilities extracted from currency option prices shows the euro trading with a negative bias through the early part of 2025, a recovery is still seen playing out later in the year. We would suggest that hedgers adopt a similarly-balanced perspective: putting all your chips on a sustained move through parity could prove painful. Instead, use a range of limit orders to seize opportunities as they are created, and layer in trades over time.

*The BIS ratios follow a methodology that is designed to be internationally consistent, and differ slightly from the versions reported by national statistics agencies. Measures offered Statistics Canada and the Bureau of Economic Analysis cannot be compared on an apples-to-apples basis.

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