The loonie posted a strong rally yesterday, appreciating 1.14% and more than erasing last Friday’s losses. The rally was sparked by a shift in global risk appetite after the UK government walked back its profligate fiscal plans. The loonie moved closely in line with the Canadian TSX equity index throughout the day. Even the Bank of Canada’s latest business and consumer surveys were insufficient to weaken the currency, despite the weight of the evidence suggesting that the current trend of disinflation is set to continue. Although it was not reflected in the price today, the two reports have strengthened our conviction in our tactically bullish USDCAD view, as weaker inflation in Canada should lead to lessened monetary tightening in Canada relative to the US. We think the market is just awaiting a fresh catalyst to start pricing this, but it could come in the form of Wednesday’s CPI report. Today, we’ll receive Canadian housing starts for September at 13:15 BST / 08:30 ET. The consensus estimate, at 265k new starts, is roughly in line with August’s print.
The dollar fell just over a percentage point yesterday as measured by the DXY index. This was primarily due to the feel good factor from UK bond markets leaking into core bonds as a whole, boosting risk appetite across the board. The 11 basis point drop in the 2-year inflation-adjusted Treasury yield was all the equity market bulls needed to move some of their overweight cash allocations back into the market following weeks of light positioning after end-Q3 adjustments. This resulted in the S&P500 posting a rally of 2.65% in yesterday’s session, while the more interest rate sensitive NASDAQ index posted gains just shy of 3.5%. Despite the dollar’s difficulties in returning to September’s highs over the previous weeks, we still think it is too early to call the top in the broad dollar, especially as inflation conditions could force the Fed to continue hiking at a faster rate and hold at these levels for longer than G10 peers. Instead, with a relatively light data calendar this week, we think some fatigue is setting in ahead of next week’s PCE data and the following week’s Fed decision and payrolls report.
The euro largely benefited from the risk rally yesterday along with the continued decline in energy prices on the back of a windier and warmer start to the continent’s winter than many feared. The medium-term energy benchmark for Europe, the 1-year ahead German baseload, fell to its lowest level since early August yesterday. The last time this level in the medium-term energy contract was achieved was when EURUSD was trading north of parity. The decline in general energy prices was largely due to the reduction in near-term gas prices, with the benchmark Dutch gas future falling to levels not seen since mid-June. While the improvement in the energy outlook has been welcomed and could see EURUSD retrace back towards parity in the coming days as the US data calendar poses no material risk to higher Treasury yields, we don’t expect the parity threshold to be breached given the slowing momentum in the eurozone economy and still elevated levels of inflation. On the latter point, speaking yesterday with the Financial Times, France’s central bank head Villeroy de Galhau stated that he expected the central bank to “go quickly” until its deposit rate hits 2%, after which, more gradual and flexible interest rate hikes will occur. This all but solidifies our view that the ECB will hike rates by 75bps next week to 1.5%. Today, with signs of further energy unity in the pipeline as EU leaders are reported to unveil a new package aimed at collective bargaining in energy markets and measures to curb intraday volatility in energy derivatives, the single currency may continue its rally back towards parity. However, still low economic sentiment is likely to stand in its way of posting a large daily rally. This will be seen in the German ZEW data at 10:00 BST but also in market positioning as the positive energy developments still fall short of a eurozone-wide energy cap and supra-national bond issuance to shelter the economy from the energy hit.
The feel-good factor returned for the pound yesterday as it notched a 1.77% rally on the day to completely reverse Friday’s losses. This was largely due to the risk premia being priced out of UK government debt as fiscal consolidation took place at a time when market participants were still wary over the bond market’s capacity to function smoothly in the absence of the BoE’s liquidity provisions. The extreme intraday volatility wasn’t just isolated to sterling, however, as the retracement in UK bond yields following Chancellor Hunt’s statement yesterday reverberated across the core yield space, boosting risk appetite in all corners of the global market. Although the mini-budget has almost been entirely scrapped now, thanks to Chancellor Hunt’s decision to reverse income and dividend tax cuts, trim the length of the energy price guarantee scheme to April 2023, and reinstate VAT measures for overseas shoppers, the damage to sentiment, especially for foreign investors, has already been inflicted. Additionally, the measures taken haven’t necessarily improved the UK’s economic outlook and a budgetary shortfall still exists. The consumer is now less protected against the stagflationary hit next year amid higher income taxes and the removal of government energy support under the current measures, while the BoE now faces a more elongated inflation outlook that will require a more persistent period of restrictive monetary policy. Given this, we think the boost to the pound can largely be seen as a temporary relief rally, evident in the fact that GBPUSD failed to break its post-budget range in the aftermath of the statement. We continue to hold our bearish view on sterling heading into the winter months where we expect growth data to signal the UK has entered the beginning of the long projected recession. Today, following on from a relatively limited overnight session for G10 FX excluding NZD, the pound’s underperformance is already visible. This takes place despite the positive developments seen in the bond market, with the Financial Times reporting that the Bank of England will further delay its active gilt sales programme after judging the market was highly “distressed” in previous weeks. While the pound may change course once the gilt market opens on a positive foot, we favour further GBP underperformance over the course of Q4 as things stand.