New low! The Canadian dollar broke to a new cycle low yesterday, the weakest level seen since September 2020, 24 months ago. This followed an optimistic CPI report that showed broad-based signs of slowing price growth. Given that inflation is coming down faster than expected and tells a similar story no matter how you slice and dice the data, the pressure on the Bank of Canada to tighten policy has come off slightly. As a result, Canadian bond yields fell, weighing down on the loonie. This morning, CAD has extended its losses as equity futures strike a risk-off tone. The data calendar is sparse until the Fed decision, so we probably won’t get a large move until then, when the removal of that event risk will allow traders to enter the positions they want to hold.
After a fairly benign session yesterday, the broad dollar is on the offensive this morning ahead of tonight’s Federal Reserve meeting. The dollar DXY index has rallied over 0.6% already this morning, carving a fresh 20-year high in doing so as traders position for a more hawkish policy decision. While this can come in many shapes and forms, we don’t expect it to come via a 100bp rate hike. Instead, we believe commentary from Chair Powell will continue to be as hawkish as it was in Jackson Hole, while the dot plot will do most of the heavy lifting. Here, we expect the median rate projection for 2022 to rise to 4% at a minimum, with another 25bps baked in for 2023 at least. The inclusion of the 2025 dot could also be another area in which the Fed relays a hawkish message as it could signal restrictive monetary policy for some time by forecasting rates above the longer-run projection of 2.5% and above the estimated neutral range of 2-3%. With this view largely the consensus, however, with 2-year Treasury yields sitting just shy of 4% and the 10-year trading above 3.5%, the question will be whether the Fed can live up to the markets’ hawkish expectations. The decision is released at 19:00 BST, with Chair Powell taking the lectern at 19:30 BST.
The single currency is feeling the pressure from the other side of the Atlantic as interest rate differentials widened yet again ahead of tonight’s Fed meeting. Although bond yields are retracing somewhat this morning, the spread between front-end Treasuries and Bunds sits at over 2.2%, while cross-currency swaps–the exchange of short-term interest rates–continue to sit in deeply negative territory, suggesting there is a larger premia on dollar liquidity at present. Adding to the euro area’s woes is Putin’s announcement of “partial mobilisation” this morning, which suggests as many as 2 million reserve personnel and a further 2m military personnel that have seen combat in the past 5 years could undergo conscription as Russia seeks to protect its interests from the west. This is generating a haven bid in German bunds, which is dragging core yields in the euro area lower, and exacerbating the widening spread on front-end differentials. Sitting 0.7% lower this morning and just 0.4% off of its multi-decade lows printed earlier in September, a hawkish Federal Reserve and an escalation in military operations in eastern Ukraine could spell disaster for the single currency today.
The pound continues to exhibit a downward bias as it drops this morning under renewed dollar strength to touch fresh lows last seen in 1984. With the economic calendar unlikely to come to the pound’s rescue until Thursday at least, sterling is likely to continue playing to the Fed’s tune today. Although the Bank of England could cover off the Fed’s latest move by hiking more than 50bps tomorrow, it isn’t our base case. Instead, we expect them to signal that they could increase the pace of their tightening cycle should core inflation pressures persist. For markets, Friday’s budget will therefore hold the key. Following on from the household support package announced last week, the Times are reporting this morning that Prime Minister Truss is prepared to cut taxes and scrap the cap on bankers bonuses, while also potentially trimming the level of stamp duty on home purchases. This only exacerbates concerns over the source of government financing that has weighed on sterling over the past month.
The Fed could force the Bank of Japan into action this evening should its announcement continue to widen back-end yield differentials between the US and Japan. This comes after former FX chief Yamasaki stated to Bloomberg that authorities are ready to intervene at any moment following last week’s rate check. Given the BoJ spent over 1trn JPY this morning protecting its yield curve control policy in markets, a sign that the central bank is unlikely to change its policy stance at tomorrow’s meeting, the central bank could be forced into intervening should the US central bank send the Japanese yen back towards the 145 handle – the perceived line in the sand.