by Marc Chandler
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We have all experienced how capital markets exaggerate. A few months ago, the focus was on the carry-trade, then the unwind. More recently, it was the euphoria around the numerous measures Beijing announced to support the property and stock markets and the attempt to reduce the risk of the local government debt. And now, as the US election approaches, it has become an important market driver. If the markets were fully rational, we might explain that the maximum uncertainty requires discounting the most impactful result.
It is ironic that a few months ago, the dollar was sold on ideas that Donald Trump would beat Joe Biden and Trump, and later his vice president pick JD Vance, argued the dollar was overvalued and its depreciation would be part of larger plan to bring industry back to the US and reduce the trade deficit. However, in recent weeks, and as the polls stay tight, the narrative has shifted. There are three main economic implications of a Trump victory, if he does as he says: accumulation of more debt, pushing up interest rates, which boosts the dollar. Tariffs are paid by the importer, but the exporter also suffers from a reduction in demand. His thrust is not about near-shoring, but reshoring production.
In the 1980 campaign, Ronald Reagan proposed a North American free-trade zone. It took a little more than a decade to achieve it, and under Trump's watch, it was modernized, and domestic content rules were tightened. In a recent campaign speech, Trump was critical of the automakers who produce cars in Mexico. that are exported to the US. The broad tariff regime Trump threatens would hurt Europe and Japan. Of course, the impact, will also be a function of the extent of the retaliation, and it is not clear what is campaign rhetoric, negotiating positions, and policy intent.
To be sure, it is not as if the Democratic candidate Kamala Harris has plans to reduce the deficit. Nonpartisan analysis suggest she will also lead to greater US debt. Some high profile investors, like Larry Fink, founder and CEO of Blackrock, and Paul Tudor Jones, one of the first modern hedge fund managers argue that regardless of who is the next US president, there will be higher inflation and more Treasury supply.
Two days after the US election, the Federal Reserve will most likely reduce its Fed funds target by a quarter-point to 4.50%-4.75% as it takes another, albeit smaller step, to reduce the extent of the policy restriction. Even though the US economy continued to grow above trend (2.8% in Q3 23), due to the lag, monetary policy is set not for current conditions but the trajectory.
The Federal Reserve last hiked rates in July 2023, when the PCE deflator had already been more than halved from the peak in June 2022 (7.2%) to 3.3% in June 2023. As of September 2024, it stands at 2.1%. But the Fed funds target has only been reduced by 50 bp. Adjusting the nominal Fed funds target by the current PCE deflator warns that monetary policy may be more restrictive now than a year ago.
China, the world's second-largest economy has announced a series of measures that appear aimed at supporting the property and equity market and putting the local governments on more stable financial footing. Many critics call on Beijing to boost consumption, which on a per capita basis has doubled in the past decade. Still, they argue that consumption is only around 53% of GDP.
Yet, the ideological and political competition with China, and the sheer size of the economy prevents more robust analysis. China's consumption as a percentage of GDP is broadly in line with Japan, Germany, the third and fourth largest economies, and is higher than Taiwan's and Australia's. Still, China reportedly will embark on a month-long campaign to promote consumption, with five large cities targeted (Shanghai, Beijing, Guangzhou, Tianjin, and Chongqing). These cities are home to around 100 mln people, or about 7% of the country's population. China's National People's Congress meets in early November, and many expect more measures, especially to bolster domestic demand, to be forthcoming.
The other main criticism levied at China by many western economists is that it relies on the aggregate demand generated by other countries. China, they argue, is dependent on exports. Yet, China exports a smaller share of its GDP than many high-income countries. It exports around 20% of GDP. And even that needs to be adjusted to recognize that almost a third of China's exports are from foreign-invested companies (joint ventures between domestic and foreign companies or wholly owned foreign companies using China as an export platform). The European Union exports more than 20% of its GDP, with Germany exporting more than twice that. France exports almost a third of its GDP. Canada exports slightly more than a third. In proportion to its output, Mexico exports almost as much as Germany.
This suggests that even if China were a parliamentary democracy, its sheer size would be disruptive of the world economy. The emergence of Japan was disruptive in the 1970s and 1980s, but accommodations were made. The yen appreciated markedly. There were, of course, various attempts, both unilateral and multilateral to manage the exchange rate, and trade tensions rose.
The combination of the yen's appreciation and trade barriers encouraged Japan producers (think automakers and part suppliers) to build and buy productive capacity abroad. That is the global players produced locally, rather than rely on exports. In turn, the accommodation also required that potential host countries be willing to accept that investment. This precedent may not be fully applicable to China.
In addition to the US election and the trajectory of Fed policy and developments in China, a third broad force shaping the investment and business climate is quick decline in price pressures. In several G10 countries, headline CPI has slowed to less than 2%. This encourages central banks to extend the easing cycle. The ECB cut rates at back-to-back meetings, and some think a 50 bp cut in December is on the table. The Bank of England will most likely deliver its second quarter-point cut after initiating the easing cycle in August, but after the budget the market pared the odds from nearly 100% to around 80%. The pendulum of market sentiment has swung back from discounting about a 60% chance of another cut in December to less than 15% since the budget announcement.
Having cut rates by 75 bp in three moves beginning in June, the Bank of Canada delivered a 50 bp cut last month. The swaps market is pricing around a 50% chance that it cuts another half-point in December. The Reserve Bank of New Zealand followed its August quarter-point cut with a half-point move in October. Another half-point cut is fully discounted for the meeting in late November and pricing in the swaps market is consistent with a little more than a 25% chance of a 75 bp cut.
The easing of trajectory of monetary policy stands in contrast to the sharp backing up of markets rates. It appears US rates pulled European rates higher. The 10-year US yield rose 40 bp in October, before the weather-distorted October US jobs report. Concern about the coming supply weighed on UK Gilts and yields rose by more than 20 bp, twice as much as Germany, which led the eurozone higher last month with its 12 bp increase.
Among the G10 currencies, the euro was the best performer, falling only 2.25% in October. The Japanese yen was the weakest performer among the G10 members. It lost 5.55%. On average, the G10 member currencies fell by 3.8%. The average emerging market currency component of the BWCI fell by about 3%. However, the impact on the index was twice as much for the G10 currencies. The Indian rupee was the best performer. It slipped by about 0.35% in October. The Chinese yuan was next with a 1.4% loss. However, the Mexican peso also performed relatively well and is considerably less closely managed than the rupee or yuan. The peso declined by almost 1.75%.
U.S. Dollar: Rising US interest rates supported the dollar in October. At first, rates extended their rise that began late September following the Federal Reserve's half-point rate cut amid what seemed like position-squaring. Rates got an additional boost from the stronger than expected September jobs report. However, as the month progressed, the narrative changed. Interest rates continued to back up but on ideas that regardless of the election outcome, the supply of US Treasuries was seen increasing (larger deficits and more debt) and boosting inflation. The US two-year yield rose by more than 60 bp since the last FOMC meeting. Yet, the economy appears to be evolving broadly in line with Fed expectations and this means that it will cut rates at the November 7 meeting. While there have been some doubts expressed about the outcome of the December meeting, the derivatives market is discounting about an 80% chance of another quarter-point cut. The October CPI will be reported on November 13 and the year-over-year headline and core rates are likely to rise slightly, but the Federal Reserve will have another CPI report in hand before it meets in December. The election is the large known unknown that is bound to impact the global capital markets. Given the polls, betting markets, and comments by managers of large pools of capital, a Trump victory would not be as surprising as in 2016. And some believe that much of talk about across-the-board tariffs are negotiating positions not necessarily policy objectives. Still, a Harris victory would be seen as less disruptive to the world economy and therefore fan risk appetites.
Euro: The euro fell for the first time in four months in October. It was driven by firmer US rates and ideas that the October ECB rate cut was in addition to a cut in December. The market has toyed with the idea of a half-point move. That speculation dampened after the stronger than expected Q3 GDP, during which Germany unexpectedly expanded, avoiding back-to-back contractions, and the October CPI was slightly firmer than expected. Even though the US and the eurozone do not have a free-trade agreement, the Trump threat of a broad tariff regime would be a significant disruption. The euro continues to broadly track the US-German two-year interest rate differential. It bottomed a little before the euro did in late September near 135 bp, helping boost our confidence the that $1.12 area was going to mark a near-term top. The premium widened to poke above 200 bp to near high for the year seen in April. It has pulled back to around 185 bp, which, with the stretched momentum indicators, suggest a bottom may be being forged. In a rising European interest rate environment, we note that the peripheral premium over Germany narrowed in October, including the French premium, despite now two main rating agencies putting it on negative credit watch. S&P cut France's rating earlier this year to AA-, its first cut of the rating since 2013. It may join Moody's and Fitch and adopt a negative outlook.
(As of November 1, indicative closing prices, previous in parentheses)
Spot: $1.0835 ($1.1160) Median Bloomberg One-month forecast: $1.0925 ($1.1140) One-month forward: $1.0850 ($1.1175) One-month implied vol: 6.9% (5.9%)
Japanese Yen: The backing up of US yields and uncertainty following the indecisive outcome of Japan's election, where the governing coalition of the LDP and Komeito Party lost their majority, helped spur among the largest monthly yen declines in at least a couple of year. The yen fell around 5.5% to return to levels last seen in late July. The most likely scenario in Japan seems to be a minority LDP-led government that relies on the support of independents and other parties on an issue-to-issue basis, or the Democratic Party for the People joins the coalition. In either event, a large fiscal package is likely that will offer household subsidies. The 2023 supplemental effort was JPY13 trillion (~$86 bln), and this year's will likely be larger. The Bank of Japan is not finished normalizing monetary policy. Governor Ueda is clear that if the economy continues to evolve the way the central bank expects, it will raise rates further. The BOJ forecast growth to accelerate next year to 1.1% from 0.6% this fiscal year. Core CPI is expected to move back below 2% in the next fiscal year, which, of course, is not independent of what the BOJ anticipates doing. The yen's depreciation in October and elevated volatility did not seem to spur much angst from Japanese officials and verbal warnings were minor and mostly indirect.
Spot: JPY153.00 (JPY142.20) Median Bloomberg One-month forecast: JPY148.60 (JPY142.25) One-month forward: JPY152.45 (J142.10) One-month implied vol: 11.8% (11.6%)
British Pound: Sterling's 3.55% drop in October was the largest monthly loss since September 2023. It had reached a two-and-a-half year high near $1.3435 in late September and fell through $1.29 at the end of October, post budget. Momentum indicators are stretched, but sterling could fall toward $1.28. A move above $1.3100 lifts sterling's technical tone. The Bank of England meets on November 7 and the market is confident (~80%) that a second quarter-point cut will be delivered (first was in August). However, the odds of a December cut been pared to less than 15% from around 60% before the budget announcement. Still, there is plenty of data, especially the employment report on November 12 and the October CPI on November 14 to which the markets (and BOE) seem particularly sensitive. Labour's first budget will boost UK taxes to a record 38.3% of GDP in 2027-2028, according to the Office for Budget Responsibility. Still the taxes and borrowing are largely for investment as the day-to-day public spending will increase by 1.5%. The Tories had penciled in a 1% increase. Market participants did not like it. The 10-year Gilt yield had fallen to around 4.20% before the budget announcement and within 48 hours was above 4.50% and finished October near 4.45%. It was last at these levels in November 2023.
Spot: $1.2925 ($1.3375) Median Bloomberg One-month forecast: $1.2965 ($1.3355) One-month forward: $1.2930 ($1.3380) One-month implied vol: 7.8% (6.8%)
Canadian Dollar: The Canadian dollar fell by nearly 3% in October. The Bank of Canada is among the most aggressive central banks this year. It cut its target rate by 75 bp in Q3 and by half-point in October. The decline in headline inflation to 1.6% (from 2.0%) was more important for officials than the flat core measure and the 112k jump in full-time jobs in September, more than the first eight months of the year combined. There is another employment and CPI report before the Bank of Canada meets next on December 11, but at this juncture the swaps market is discounting a little more than a 50% chance of another half-point cut. The central bank is front-loading rate cuts this year and swaps market has another 90 bp of cuts between now and the end of H1 25. The US two-year premium over Canada has widen to over 110 bp and is the highest since 1997. Meanwhile, political pressure on the Liberal minority government is set to increase and the risk of a political crisis that topples the government cannot be ruled out. Even if the government survives, Trudeau's Liberals are so out of favor that it could fuel a resurgence for the Bloc Quebecois and renew talks about another referendum for independence. The next national election must be held by late October 2025. The US dollar looks set to take out the year's high set early August near CAD1.3945. The greenback has not traded above CAD1.40 since the pandemic-inspired turmoil in H1 20. Then, Canada offered about a 20 bp premium to the US.
Spot: CAD1.3950 (CAD 1.3515) Median Bloomberg One-month forecast: CAD1.3765 (CAD1.3515) One-month forward: CAD1.3935 (CAD1.3520) One-month implied vol: 5.4% (4.6%)
Australian Dollar: The Australian dollar appreciated by 5.7% in August and September and gave it most of it back in October, falling 4.8%. The New Zealand dollar fell by 5.8% and its central bank delivered a 50 bp rate. The market is pricing in another large cut by the RBNZ before the end of the year. While dramatic rise in US rates underpinned the US dollar broadly, the Australian dollar may have also been dragged lower by the unwinding of some of the euphoric initial reaction to China's supportive measures. The Reserve Bank of Australia finally persuaded the market that it would not cut rates this year, but the soft Q3 CPI (2.9% vs. 3.8% in Q2) boosted the odds of a cut in Q1 25. The RBA meets on November 5 and is likely to maintain its neutral stance. The Australian dollar's retracement is deeper than we expected, and the risk is that the losses may extend toward $0.6470-$0.6500 in November. A move above the $0.6625-50 area would lift the technical tone.
Spot: $0.6560 ($0.6905) Median Bloomberg One-month forecast: $0.6590 ($0.6870) One-month forward: $0.6565 ($0.6910) One-month implied vol: 10.0% (9.2%)
Mexican Peso: The dollar rose against nearly all emerging market currencies in October. The JP Morgan Emerging Market Currency Index fell 3.1%, the first decline in three months. The MSCI Emerging Market Currency fell around half as much, falling for the first time in four months. The peso's decline of about 1.75% made it among the better performing emerging market currencies and the best in the region. Selling the peso was supposed to be part of the "Trump trade" on as his broad tariff threat and wanting to re-shore production that had migrated to Mexico, including autos. The USMCA agreement will be reviewed next year and finalized in 2026. Mexico's central bank meets November 14. There are two known unknowns that will drive the peso in the coming weeks: the US election and domestic developments in Mexico. The minutes of the September central bank meeting seemed to lay the groundwork for another cut, but the peso's weakness and the firmer than expected CPI for the first half of October makes it a close all. The volatility may create opportunities for nimble participants. With the dollar at new two-year highs, the MXN20.50-MXN20.60. may be the next important chart area.
Spot: MXN20.28 (MXN19.69) Median Bloomberg One-Month forecast: MXN19.92 (MXN19.55) One-month forward: MXN20.39 (MXN19.79) One-month implied vol: 18.4% (14.7)
Chinese Yuan: The yuan tracked the broad movement in the dollar. As the dollar fell in Q3, the onshore yuan rose by 3.5%. As the market reassessed the trajectory of Fed policy, the dollar recovered in October. Many outside critics do not believe Beijing's measures are sufficient to turn the situation. More efforts are expected to be unveiled in the coming weeks, and lower rates, including reserve requirements are possible before the end of the year. The National People's Congress session concludes a few days after the US election, and some suggest a package to promote domestic demand of as much as CNY3 trillion (~$420 bln). Idiosyncratic factors in Japan and China have loosened the correlation between changes in the yen and yuan from above 0.80 in Q2 to almost 0.2 in at the end of Q3. It is below 0.30 at the end of October. Instead, the yuan is moving more in line with the Dollar Index. The rolling 30-day correlation of the changes in the yuan and DXY rose from almost 0.50 at the end of September to near 0.70 at the end of October. After bottoming near CNY7.00 in late September, the dollar moved into a CNY7.10-CNY7.13 range in the last couple of weeks. We suspect the dollar's recovery is nearly over, but there may still be scope into the CNY7.15-CNY7.18 area.
Spot: CNY7.13 (CNY7.01) Median Bloomberg One-month forecast: CNY7.11 (CNY7.04) One-month forward: CNY7.10 (CNY6.98) One-month implied vol: 6.8% (6.0%)
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