Three weeks ago the trade was simple: the Federal Reserve was the hawk, the European Central Bank was the follower, and the dollar was the place you parked money while you waited. On Wednesday the dollar index sat at roughly 99.46, its weakest level in three months, and both halves of that trade had quietly reversed.
The Fed side collapsed first. Futures pricing now puts the odds of a September rate rise near 30%, down from a peak above 80% in late July. Two data prints did it. July payrolls came in at a loss of 23,000 jobs against expectations of an 85,000 gain, with downward revisions to prior months. July CPI landed on consensus at 0.1% monthly and 3.4% annual, with core at 2.5% — hot enough to keep the committee uncomfortable, not hot enough to justify moving into a weakening labour market. Retail sales then fell by the largest margin in more than a year.
The European side moved the other way. Most economists now expect a 25 basis point increase at the ECB’s 10 September meeting — a Reuters poll had 57 of 69 forecasting a rise in the deposit rate to 2.50% — after ECB president Christine Lagarde flagged the rebound in oil prices as an upside risk to the euro-area inflation outlook. A September move is close to fully priced.
Our take: The dollar is not weak because America is weak. It is weak because the interest-rate gap that made holding dollars profitable is closing from both ends at once — the Fed pricing out a hike it was expected to deliver, the ECB pricing in one it was not. That is a relative-value story, not a growth story, and it is why the same week can deliver a softer dollar and a higher equity close.
The equity market took the trade-off happily
Wednesday snapped a three-day losing run. The S&P 500 added 0.21% to close at 7,707.98, the Nasdaq Composite rose 0.16% to 26,331.09, and the Dow gained 119.65 points, or 0.22%, to 53,463.05. The proximate cause was the bond market: the 30-year yield fell about 10 basis points to 5.18% after the Treasury said it would increase buybacks of longer-dated debt, days after the long bond had touched a 19-year high.
Chipmakers were the notable exception, falling while most S&P constituents rose. That split is the tell. A market repricing the Fed lower rewards the parts of the index that are sensitive to discount rates and unloved on valuation, and does comparatively little for the crowded trade that was already priced for perfection.
Why the currency move matters more than it looks
A softer dollar is a quiet earnings tailwind. A large share of S&P 500 revenue is earned outside the United States, and a weaker dollar converts that revenue into more reported dollars. It also loosens financial conditions for emerging-market borrowers holding dollar debt, and it makes imported goods more expensive at exactly the moment US inflation is still running above target at 3.4%.
That last point is the uncomfortable one. The reason the Fed is being priced out of a hike is soft activity data. The consequence of being priced out is a weaker currency, which is mildly inflationary. If the September FOMC meeting arrives with inflation still sticky and the dollar another two or three per cent lower, the committee that already produced three dissents in July will not have got any easier to chair.
What to watch
- The 10 September ECB decision. A hike is priced. What is not priced is the guidance that comes with it — whether Lagarde signals this is a one-off energy response or the start of a sequence.
- Oil. The ECB’s hawkish turn is largely an energy story. If crude retraces, the September case weakens and the euro leg of this trade unwinds fast.
- US labour data. The August payroll report is the single input that can put a Fed hike back on the table or take it off permanently. A second negative print changes the conversation from “pause” to something else entirely.
- Import prices. The lagged effect of a weaker dollar shows up here first. It is the earliest read on whether the currency move starts feeding back into CPI.
The market spent July convinced the Fed had one more move in it. It spent August discovering the data disagreed. The dollar is simply the fastest instrument to reflect that, and right now it is telling you the policy gap that defined the first half of the year has stopped widening and started to close.