Market Brief: Markets Steady Ahead of Fedspeak Deluge

Financial markets are seeing consolidative trading patterns take hold after last Wednesday’s bold and decisive move from the Federal Reserve. The dollar is advancing off Friday’s lows, long-term Treasury yields are rising, equity futures are pointing to a healthy open, and the VIX “fear index” - a measure of expected volatility - is pushing lower, suggesting that policymakers succeeded in delivering an emergency-sized rate cut without convincing investors that an emergency is underway.

This week, words might speak louder than actions. The Conference Board’s consumer confidence index will drop tomorrow, Thursday will bring durable goods orders and weekly unemployment claims, and the Federal Reserve’s preferred inflation indicator - the core personal consumption expenditures index - will land on Friday. But with Chair Powell, Vice Chair Williams, Governors Barr, Bowman, Cook, and Kugler, Atlanta’s Bostic, Chicago’s Goolsbee, Minneapolis’ Kashkari, and Boston’s Collins all scheduled to make appearances in the coming days, markets are likely to focus on what officials say about the central bank’s reaction function.

Although most are likely to emphasise the central bank’s data-dependence, working to convince markets that there is no pre-set easing path ahead, there is considerable uncertainty around which pieces of data are most important, and how aggressively officials are willing to respond. Governor Waller last week appeared to say that a faster-than-expected decline in inflation - not the rising unemployment rate - played the deciding role in justifying a jumbo-sized rate cut, and Powell’s comments during the press conference seemed to indicate that policymakers would prefer to deliver smaller cuts at subsequent meetings. Investors have been working under the assumption that a softening in labour markets was driving Fed policy, and have placed a heavy emphasis on relatively-small changes in non-farm payrolls reports, but it is possible that this assumption is misplaced - and if it is, the volatility roadmap could be redrawn.

The gap between market expectations and Fed guidance has narrowed. Investors have three quarter-point rate cuts discounted by year end - one more than the two shown in the Fed’s latest dot plot - and four in 2025, against three in the dot plot.

Both the pound and euro are suffering losses after business activity measures missed forecasts, reinforcing market expectations for rate cuts at upcoming central bank meetings. In the UK, purchasing manager indices for the manufacturing and services sectors dropped, dragging the composite index down to 52.9 in September from 53.9 in the prior month, and price pressures continued to ease, giving the Bank of England the room and motivation to cut rates again in November. On the other side of the Channel, the composite index tumbled to 48.9 in September - down from August’s 51 - and below the 50 threshold that separates expansion from contraction. Odds on a cut at the European Central Bank’s meeting next month have almost doubled to 45 percent from around 25 last week, indicating that hopes for an economic rebound are fading, and helping justify a more aggressive normalisation in policy settings.

China’s yuan is trading lower after the People’s Bank reduced interest rates and scheduled a press conference with Governor Pan Gongsheng, reigniting hopes for a more conclusive round of economic stimulus efforts. The central bank cut its 14-day reverse repurchase rate to 1.85 from 1.95 percent, and said the governor would outline measures designed to provide “financial support for economic development” at tomorrow’s meeting with reporters, triggering a rise in onshore stock indices and a decline in government bond yields. We’re not sure whether the Bank’s moves are really reflective of a change in stance - officials may be working to inject additional liquidity ahead of next week’s national holiday - but it is clear that the economy needs additional support. A slow-motion collapse in the country’s long-overheated property market has demolished consumer demand growth, and an overcapacity-ridden factory sector is exporting deflation to the rest of the world, putting downward pressure on price indices in the US and other major economies.

We think the Bank of Canada will continue to ease policy in quarter-point increments at each meeting through to early next year, but last week’s jumbo-sized cut from the Fed may have lowered the psychological bar for a similarly-proportioned move at the Bank’s October meeting. Gross domestic product estimates for July and August, out on Friday, are expected to show the economy losing momentum in the third quarter, and could - in combination with another potentially-negative jobs report - help bolster odds on a half-percentage-point cut next month.

This view isn’t far off market consensus. Although the Fed’s policy path still looks slightly front-loaded, traders expect US and Canadian policymakers to act in virtual lockstep over the next seven meetings, delivering a total of seven rate cuts each. It is this fact that has kept interest rate differentials stable, limiting the extent to which the loonie has fluctuated against the dollar - even as the timing of specific moves has shifted around. To us, this means that the next currency catalyst will have to come from something outside the monetary policy sphere - with the US election looking like the most likely trigger for a move that pushes the dollar-Canada pair out of its current equilibrium.

It’s early days, but a more constructive outlook seems to be forming around the Mexican peso*. Domestic political risks, the threat of another flare up in trade tensions, and the unwinding of the yen-funded carry trade dealt the currency a series of blows this summer, but with a more centrist leader poised to take the reins next week, Trump’s polling odds edging downward, and global rate expectations resetting lower, we’re seeing signs of a floor emerging around the 20 threshold on interbank markets, suggesting that a modest recovery could be in the offing. The Banco de México is likely to cut rates in another quarter-point increment at this Thursday’s meeting - which will reduce the policy differential relative to the Fed - but swaps markets are pointing to a modest narrowing over the year ahead, meaning that the peso is still seen generating an above-525 basis-point yield premium over the dollar. Absent a major shock, inward carry trade flows could pick up once the US election has concluded.

*I've been repeatedly wrong on the peso since June, so take this with a big grain of Colima sea salt.

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