Market Brief: Mean reversion kicks in, forcing yields and the dollar into retreat

Treasury yields are slipping for a second day as an early-week barfing episode gets washed out of markets, the dollar is retreating, and rival currencies are edging higher ahead of the North American equity open.

Orders for durable goods fell by more than expected last month, but changes in aircraft orders obscured a relatively-positive read on underlying fundamentals. On a headline basis, new orders for goods meant to last more than three years fell -0.8 percent in the United States in September, but core capital goods - which exclude aircraft and defence products - climbed 0.5 percent, building on August’s 0.3-percent advance.

I wonder however, if there isn’t a front-running effect involved. With the American manufacturing sector remaining heavily reliant on imports from lower-cost jurisdictions - including China - it makes sense for factories and major retailers to order products for delivery ahead of a potential rise in tariffs by February next year. It’s highly speculative to suggest*, and I don’t have much more than anecdotes to go on, but it’s possible that a number of key economic indicators are being flattered in an unsustainable way, helping push the dollar further into overvalued territory, and setting the stage for a reversal in the winter months.

There’s no lettuce involved yet, but next week’s Autumn Budget is causing some consternation in British markets. Finance minister Rachel Reeves is expected to change a fiscal rule that would enable an increase in borrowing - by more than £50 billion pounds - which would presumably help boost growth in the short term, while worsening the country’s debt position and slowing the Bank of England’s easing trajectory. Gilt yields are pushing higher this morning, but currency options markets - in which participants take a probabilistic perspective on future outcomes - are expressing a relatively balanced view on the sterling’s likely performance over the next year, with implied probabilities tightly clustered around the 1.30 threshold. We think this understates the potential for upside in the pound, but waiting for a rally in the pound can often seem like waiting for Godot - it never seems to arrive.

The euro is roughly flat, pinned in place by countervailing narratives from officials at the European Central Bank. Governing Council member Pierre Munsch yesterday told Bloomberg “I don’t see why we should have a discussion on a 50 basis-point move in December - I really think it’s premature”. Speaking at the IMF meetings in Washington, his counterpart Mārtiņš Kazāks said he was deeply concerned about the economy, saying that inflation is retreating “much faster than expected,” - “We shouldn’t hold rates at high levels for longer than necessary”. Euro-area purchasing manager indices remained in contraction in early October, suggesting that elevated rates are still taking a toll on growth.

The Japanese yen is trading with a distinct defensive bias ahead of this weekend’s election, which could weaken the ruling coalition’s hold on parliament, and complicate the country’s monetary tightening trajectory. Data released overnight showed inflation in Tokyo falling below the 2-percent threshold for the first time in five months in October, with falling energy prices helping pull the headline print lower. Bank of Japan Governor Kazuo Ueda yesterday indicated that the central bank would not raise rates next week, confirming existing market views and helping keep interest differentials under pressure.

The Canadian dollar is edging higher after the country’s statistics agency said consumers increased spending in September, adding to a series of data releases that might be interpreted to mean that the Bank of Canada’s easing efforts are translating into an improvement in sentiment and activity levels. Retailers reported a 0.4-percent monthly rise in receipts, but “core” sales - which exclude auto purchases - fell 0.7 percent, indicating - to us at least - that households are constrained by ever-rising debt carrying costs, and remain extremely cautious.

We don’t have a strong-conviction view on whether the Bank will deliver another half-percentage-point rate cut at December’s meeting. Markets are currently putting 39-percent odds on a second consecutive outsized move, and we see a downshift to quarter-point cuts as the path of least resistance - but it’s too early to say, given that two jobs reports, an inflation update, and a gross domestic product print will be released between now and the decision date.

Yesterday’s federal government decision to curb immigration could dampen the Bank’s optimism on the country’s growth trajectory and lower long-run “neutral rate” estimates, but the immediate monetary policy implications should be relatively limited. Canada’s population is now expected to grow more slowly than the central bank projected on Wednesday, with the immigration ministry targeting a net loss of 0.2 percent a year in 2025 and 2026 - down dramatically from nearly 3 percent thus far this year, and well below the Monetary Policy Report’s 1.5-percent forecast. This might weaken marginal demand for goods, services, and housing, but will also lower the capacity of the economy to provide those things. We expect the Bank to lower its growth forecasts over coming meetings, but this should be paired with a shrinking in perceived economic slack, limiting the extent to which rates need to be moved in a more accommodative direction.

*So this is basically a wild guess.

**Apologies for the delayed distribution this morning. I recently quit drinking coffee, and it turns out to have been a big factor in my writing process.

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