01/09/2024 Market Analysis

Week Ahead: Markets in Motion

As summer transitions to fall, monetary policy and political events will significantly shape the business and investment environment. The market, initially expecting aggressive rate cuts in 2023, has now adjusted closer to central bank signals, with global rates rising and the dollar regaining strength in early 2024.

The Federal Reserve is expected to be one of up to seven G10 central banks cutting rates in September, while the Bank of England is likely to cut rates at least one more time by year-end. However, the Reserve Bank of Australia has indicated that it’s too early for them to cut rates. The Bank of Japan could hike rates by 10 basis points by year-end, as suggested by the swaps market.

The Dollar Index, which peaked in September 2022 at a two-decade high, has since been range-bound between 100-107. A slowing U.S. economy and anticipated Fed rate cuts in 2025 suggest a potential downside breakout to the 98.00 area in Q4. However, recent dollar losses in July and August have stretched technical indicators, and the risk remains that stronger-than-expected U.S. employment data could extend the dollar’s upward correction in the short term.

Between mid-July and early August, a massive position adjustment occurred in the markets, with a preference for risk assets financed by selling currencies like the Japanese yen, Swiss franc, and offshore yuan. This led to volatility across capital markets, with the yen experiencing a significant surge, dragging the dollar down in the process. Japanese investors capitalized on the stronger yen to buy foreign bonds and stocks.

The yen’s sharp moves were driven by leveraged accounts, with speculators completely reversing a large net short yen position into a net long position by late August. The unwinding of these carry trades, particularly in the yen, demonstrated the complexities of managing foreign currency exposure.

Political events in major economies could also impact the markets. Japan’s Prime Minister Kishida is stepping down, with his successor expected to maintain the current policy direction. Meanwhile, Germany faces three state elections in September, which could affect the ruling coalition’s stability.

In the U.S., the presidential race has tightened, with Vice President Harris gaining ground in the polls against former President Trump. The upcoming September debate may not be decisive but is likely to be a significant moment in the campaign.

United States of America

Fed Signals Easing Cycle Amid Labor Market Confidence

At the Jackson Hole symposium, Federal Reserve Chair Jerome Powell confirmed that the easing cycle is expected to begin in September. While inflation has not yet returned to the 2% target, Powell expressed confidence that it is on a sustainable path. He also emphasized that the Fed no longer aims to cool the labour market further. The upcoming “dot plot” in the updated Summary of Economic Projections will provide more insight, but markets anticipate at least one 50 basis point rate cut during the final three Fed meetings of the year.

Stronger Job Growth Expected

The labour market, which saw distortions in July due to a summer storm, is expected to show stronger growth in August. The unemployment rate is projected to tick down from 4.3% to 4.2%, marking the first decline in five months. Powell’s comments suggest that the Fed is now more focused on stabilizing the labour market than forcing further cooling, which could support better job growth in the coming months.

U.S. Presidential Race Tightens

With President Biden opting not to run for reelection, the U.S. presidential race has tightened. The upcoming September 10 debate between Vice President Harris and former President Trump will be a key moment in the campaign, drawing significant attention from the public and investors alike.

Dollar Index Faces Correction

The Dollar Index fell by 2.4% in August, its largest monthly decline since November 2022. After approaching the 100.00 level, which hasn’t dipped below since July 2023, the dollar now appears overextended. A technical correction has started and could continue, with a potential upside back toward the 102.50 area.

Key Points:

• Fed signals rate cuts likely to begin in September.
• The labour market is expected to strengthen, with the unemployment rate ticking down.
• U.S. presidential race tightens ahead of the September 10 debate.
• The Dollar Index is poised for a technical correction after the August decline.

Australia

Australian Dollar’s Recent Rally

In mid-July, the Australian dollar reached a six-month high near $0.6800 before market turmoil and the unwinding of carry trades drove it to a yearly low of around $0.6350 in early August. However, the currency rebounded swiftly, climbing to $0.6825 by late August. The Reserve Bank of Australia (RBA) last hiked rates in November 2022 and has maintained a hawkish stance since.

Rate Cut Uncertainty and Market Sentiment

RBA Governor Bullock has indicated that there may not be room for a rate cut this year, but market participants are still holding onto hope. Despite robust full-time job growth—nearly 150,000 jobs added in the three months through July—and sticky inflation, with underlying CPI remaining at 3.8% in July, the futures market is pricing in nearly an 80% chance of a rate cut by year-end. The market also anticipates three rate cuts in 2025. Still, no major change in tone is expected from the RBA at its September 24 meeting.

Potential for Correction

The Australian dollar’s 7.5% rally from the August 5 low has pushed momentum indicators into overbought territory as it nears its yearly high of $0.6840, set on January 2. This could lead to corrective pressures in the coming weeks, potentially pushing the currency back to the $0.6680-$0.6700 range.

Key Points:

• Australian dollar rebounded from August lows, nearing its yearly high.
• Market remains hopeful for a rate cut, despite the RBA’s hawkish stance.
• Corrective pressures could push the currency lower in the short term.

Canada

Canadian Dollar’s Recovery

In the market turmoil that peaked in early August, the Canadian dollar hit a new low for the year. However, it staged a strong recovery in the following weeks, reaching its highest level since March by the end of the month. The US dollar, which had approached CAD1.3945 on August 5, reversed sharply and found support near CAD1.3440 in late August. This move was driven by a significant reduction in short Canadian dollar positions rather than new long positions.

Potential Correction Ahead

Looking forward, corrective forces could push the US dollar to test the CAD1.3600 area, where previous support may now act as resistance. Despite the Canadian dollar’s recent strength, market participants remain confident that the Bank of Canada will implement rate cuts at its remaining meetings in 2024, with two additional cuts anticipated in the first half of 2025.

Rate Cut Expectations and Inflation

Canada’s CPI slowed from 3.7% at the end of Q3 2023 to about 2.5% in July, but the Bank of Canada has already cut the nominal overnight rate by 50 basis points. This suggests the real rate may have increased. Meanwhile, the Federal Reserve is expected to take a more aggressive approach, with the US two-year premium over Canada narrowing from a peak of 90 basis points in June to just below 60 basis points—a three-month low.

Key Points:

• Canadian dollar recovered strongly after August lows.
• Corrective pressures may see the US dollar test CAD1.3600.
• Market expects the Bank of Canada to cut rates at the remaining 2024 meetings.
• Canada’s CPI has slowed, but rate cuts have raised real rates.

Europe

Euro’s August Rally

In August, the euro briefly climbed above $1.12 for the first time since July 2023, posting its best monthly performance of the year with a 2.25% gain. However, this rally did not signal an improved economic outlook. Germany, a key driver of the Eurozone, has been struggling, alternating between growth and contraction for the past 10 quarters. Despite a return to pre-COVID trade surplus levels, Germany’s largest trading partner is now the US, rather than China. The German government faces low public confidence, which could impact upcoming state elections in September.

Political Instability in Europe

Political uncertainty extends beyond Germany. France remains under a caretaker government, and President Macron must appoint a prime minister capable of securing a parliamentary majority to pass the upcoming budget. Italy’s budget challenges are also expected to intensify in the coming months, further complicating the Eurozone’s economic picture.

Rate Cut Expectations

The European Central Bank (ECB) is expected to cut rates by 25 basis points at its September 12 meeting, marking the second cut in the current cycle. After this move, markets have priced in an additional 38 basis points of rate cuts for the rest of the year, signalling a quarter-point reduction and a possibility of more. By the first half of 2025, the market expects at least two more rate cuts with a strong chance of a third.

The euro’s rally in August left momentum indicators over-extended, and a downside correction could push the currency toward the $1.0950-$1.1000 range in the coming weeks.

Key Points:

• Euro saw its best monthly performance of 2023, but economic fundamentals remain weak.
• Germany faces ongoing economic struggles and low public confidence.
• Political uncertainty in France and Italy adds to Eurozone challenges.
• ECB is expected to continue cutting rates, with further corrections in the euro likely.

Japan

Yen’s Correlation with US Yields and Market Intervention

The 100-day correlation between changes in the yen’s exchange rate and the US 10-year yield is around 0.55, the highest since July 2023. This indicates a stronger relationship than with the 10-year interest rate differential. The Bank of Japan’s (BOJ) intervention in 2022 successfully broke the yen’s downward momentum, largely due to the strategic timing coinciding with a decline in US 10-year yields. Japanese investors capitalized on the yen’s gains by purchasing the most foreign bonds and stocks since Q1 2023, rather than merely mirroring the BOJ’s dollar sales.

Speculators and Economic Growth

Speculators in the CME currency futures market went net long on the yen for the first time since Q1 2021, signalling confidence in the currency’s potential recovery. Japan’s economy grew by 3.1% at an annualized rate in Q2 2023 after contracting by 2.3% in Q1. However, this growth likely overstates the strength of the economy, and growth is expected to slow to below 2% in the coming quarters.

BOJ’s Rate Hike Outlook and Yen’s Recovery Potential

With core inflation well above 2%, the BOJ remains committed to further tightening. The swaps market has priced in nearly 10 basis points of tightening for the end of the year, with a possibility of another 10 basis points in the first half of 2025. The US dollar bottomed near JPY143.50 in late August, and there is potential for it to recover toward the JPY148.50 area in the coming weeks.

Key Points:

• The yen’s correlation with US 10-year yields has reached its highest level since July 2023.
• BOJ intervention in 2022 successfully halted the yen’s decline.
• Japanese investors increased foreign asset purchases during the yen’s strength.
• Speculators turned net long on the yen for the first time since Q1 2021.
• BOJ is expected to continue tightening, with further gains in the yen possible.

United Kingdom

Sterling’s Recent Performance

In late August, the British pound reached $1.3265, its highest level since March 2022. This strength was fueled by the broader dollar setback and expectations that the Bank of England (BOE) might not cut rates in September, unlike several other G10 central banks. Despite this, BOE Governor Bailey has suggested the possibility of further rate cuts, with the swaps market pricing in a likely cut in November and a two-thirds chance of another in December.

Sterling’s Gains and Potential Corrections

Sterling has been the best-performing G10 currency so far this year, gaining 3.2% against the US dollar. Its 2.2% gain in August matched the euro’s performance, making both currencies the top performers in the G10 for the month. However, corrective pressures may push sterling back toward the $1.2975-$1.3030 range in the coming weeks.

Economic Conditions and Political Developments

The UK economy was the strongest among the G10 in the first half of 2024, but it is expected to moderate. Early Q3 data suggests continued robust momentum. Meanwhile, Prime Minister Starmer and Chancellor Reeves have revealed a GBP22 billion fiscal gap left by the previous government. Labour has ruled out increasing income tax, VAT, or national insurance levies, focusing instead on capital gains tax. The UK taxes capital gains at a lower rate (10%-28%) compared to income tax (20%-45%).

Key Points:

• Sterling reached its highest level since March 2022 in late August.
• The BOE is expected to cut rates in November, with a strong chance of another cut in December.
• Sterling’s recent gains may face corrective pressures in the short term.
• The UK economy remains strong, but political and fiscal challenges are emerging.