Market Brief: Slowing Global Economy Bolsters Dollar's Appeal

Against a consolidative trading backdrop, the dollar looks set to notch up an eighth week of gains, rising against most of its major rivals as economies outside the United States lose momentum in relative terms.

Business activity in the euro area shrank unexpectedly in November, kicking the comon currency down to a two-year low against the dollar. S&P Global’s composite purchasing manager index dropped to 48.5 - below the 50 threshold that separates expansion from contraction - in early November, as both the manufacturing and services sectors weakened, suggesting that businesses and consumers turned more pessimistic on the outlook. This is likely to translate into a more dovish stance from policymakers ahead of the European Central Bank’s December get-together, and will bolster market expectations for a series of back-to-back rate cuts at meetings through the early part of 2025.

The British pound is performing similarly, tumbling to a six-month low against the dollar as traders bet on a more aggressive easing campaign from the Bank of England. Retail sales fell significantly faster than expected in October, and the UK composite purchasing manager index plunged to 49.9 in November from 51.8 in the prior month, providing evidence of worsening sentiment and deep scepticism on the government’s fiscal plans. Three rate cuts are now fully priced for the Old Lady of Threadneedle Street over the next year, reducing the pound’s still-favourable rate advantage against other major currencies.

In contrast, this morning’s US composite purchasing manager reading is expected to remain firmly above the 50 threshold, further widening the wide gap in major-economy economic surprise indices - which measure the difference between consensus forecasts and realised data - that has emerged over the last six months. For now, currency market participants don’t really need the ‘Trump trade’ or a “reflationary” narrative to put momentum behind the greenback - incoming data releases are doing the job just fine.

Japan’s yen is strengthening after central bank Governor Kazuo Ueda called the outcome of December’s policy meeting “impossible to predict,” leading market participants to raise the odds on a rate hike. Inflation remained above the Bank of Japan’s target in October, according to data released this morning, with consumer prices excluding fresh food and energy rising 2.3 percent from a year earlier - up from 2.1 percent previously - suggesting that a weak exchange rate is putting upward pressure on imported product costs. Japanese government bond yields are grinding higher as monetary tightening expectations firm, narrowing the gap with their Chinese equivalents, while struggling to catch up to much bigger moves in the United States.

The Canadian dollar is trading on a stronger footing after the government announced a series of stimulus measures that could - in theory - boost growth and inflation. Under the plan, the country’s main consumption tax will be cut on a range of items for two months around Christmas, and individuals making less than $150,000* annually will receive a $250 cheque in the spring. Market implied odds on an outsized 50 basis-point rate cut at the Bank of Canada’s December meeting fell to less than 25 percent on the news - down from around 40 percent - and ten-year yields jumped by 5 basis points.

We’re not sure this market reaction is justified. Although we’ve maintained a bias for a smaller move for some time, we doubt the government’s effort truly tips the scales in a meaningful way: the combined package should help boost consumption at the margins - especially among households with a high propensity to spend - but still amounts to a sub-0.25-percent fiscal impulse in an economy that is suffering under the burden of rising borrowing costs and growing trade uncertainty. Next week’s gross domestic product release and early December’s jobs report could play more important roles in influencing the speed and extent of the Bank’s near-term easing campaign.

Against that backdrop, we should note that the recent slew of semi-apocalyptic headlines about the loonie have been somewhat exaggerated. Although the exchange rate has repeatedly broken through the psychologically-important 1.40 threshold in recent weeks, it is down just 2.2 percent from last November, marking a period of relative placidity from a long-term perspective. We don’t expect this to last - the stresses building in the global economy will eventually result in higher currency market volatility - but for now, the Canadian dollar is moving at a pace that won’t excite monetary policymakers, meaning that the Bank of Canada isn’t likely to find itself constrained by exchange rate effects.

*For those unfamiliar with prevailing exchange rates and relative price differentials between Canada and the US, this is about $50 in US dollar terms.

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