FX Markets Face a Tug-of-War: A Scenario Analysis  – Saxo Bank MENA

Markets remain tense following the labour market shock in early August, which highlighted concerns about the rising unemployment rate and fuelled recession fears in the US.

The debate between a soft landing and a looming recession has been a central theme in market discussions, and we discussed this macro theme in detail in our blog about the US Economy. However, yesterday brought a more risk-on sentiment, driven by a variety of data and earnings reports, particularly:

• US July Retail Sales: A stronger-than-expected 1% month-over-month increase against expectations of 0.4% highlighted a robust consumer sector.
• Jobless Claims: Weekly claims came in lower at 227k, further bolstering market confidence and reducing the risks of a rising unemployment rate.
• Walmart Earnings: The retail giant reported better-than-expected comparable sales and raised its profit outlook, citing a stable consumer base.

Despite this risk-on sentiment, it’s crucial to consider the potential limitations of these positive signals, which could have played a significant role in these reactions. These include:

• The extreme market positioning and the expectations of aggressive rate cuts from the Fed.
• Low liquidity typical of the summer months played a significant role in these reactions.

Consequently, these outcomes should be viewed with caution, especially considering some key caveats:

• July Retail Sales: The increase was largely driven by auto sales, which might not fully represent broader consumer strength.
• Jobless Claims: These figures tend to be volatile during the summer, making them less reliable.
• Walmart’s Performance: The positive results could be attributed to the trade-down effect, where consumers shift from more expensive retailers to more affordable options like Walmart.

USD Faces Opposing Forces, But Colluding Risks for JPY

These developments led to higher US Treasury yields as markets questioned the likelihood of a 50bps rate cut by the Federal Reserve in September. Simultaneously, the reduction in recession odds still fostered a risk-on sentiment.

The US dollar (USD) got caught between two contrasting dynamics. On one side, rising Treasury yields are boosting the dollar, reflecting confidence in the US economy and attracting yield-seeking investors. Conversely, diminishing recession concerns drive a risk-on environment, which typically puts downward pressure on the USD as investors turn to higher-yielding, riskier assets.

However, both scenarios have proven challenging for the Japanese yen (JPY), leading to a double whammy. Rising US yields have widened the yield differential with Japan, fueling carry trading and weakening the yen. Meanwhile, the reduction in recession concerns has spurred risk-on flows, further eroding the yen’s appeal as a safe-haven asset. As a result, the JPY has erased all its gains since the August 2 US jobs report, underscoring its vulnerability to these opposing forces.

Given the increasingly complex macro landscape, it is crucial to assess how different currencies might react under four distinct scenarios, defined by the interplay of yields and recession risks.

Scenario 1: Rapidly Softening Inflation, Strong Growth (Goldilocks)

Market Dynamics: Expectations for rate cuts remain, but recession concerns ease. This creates a “Goldilocks” environment where growth is strong enough to avoid a downturn, but inflation is softening.

Currency Impact: Mildly bearish for the USD as the Fed could still cut to ensure a soft landing. Gains in Emerging Market (EM) currencies and commodity currencies like AUD as risk appetite improves and global demand stabilises.

Scenario 2: Stalling/Higher Inflation, Strong Growth (Reflation)

Market Dynamics: Inflation stalls but remains elevated, while growth remains robust. This leads to the market paring back expectations of rate cuts, reducing recession fears.

Currency Impact: USD is mixed as yields rise higher, but risk-on sentiment prevails. AUD and GBP gain amid risk-on sentiment. Haven currencies like JPY and CHF underperform with higher US yields, fuelling more carry trading and haven demand wanes.

Scenario 3: Softening Inflation, Weaker Growth (Recession)

Market Dynamics: The Fed aggressively cuts to mitigate the economic slowdown.

Currency Impact: Support for Fed rate cuts and recession concerns both push haven currencies like JPY and CHF higher. These currencies outperform as investors seek safety amid economic uncertainty.

Scenario 4: Rising Inflation, Weaker Growth (Stagflation Concerns)

Market Dynamics: Stagflation fears drive haven flows into the USD. This environment could pressure the central banks, particularly the Fed, to prioritise inflation control over growth.

Currency Impact: USD strengthens as a safe haven, with flows moving away from riskier assets. Commodity and EM currencies suffer as high inflation and weak growth dampen risk appetite and global demand.

Last Updated on 5 months by News Desk 1