While the markets remain uncertain about whether the Fed will implement a 25 basis points or a 50 basis points cut, the latest labor report suggests that a 25 basis points reduction is more probable. This development helps alleviate recession fears and supports further recovery of the USD. Conversely, with the unemployment rate rising again in Canada, markets anticipate additional cuts from the Bank of Canada for the remainder of 2024.

USD: 25bps or 50bps cut?

Before the release of the US August labor data, global risk-off sentiment continued to pressure high-beta currencies and equities, driven by expectations of the Fed's easing cycle. Several US economic releases ahead of the report heightened recession fears, boosting market anticipation for a potential 50bps rate cut in September. The August Final S&P Global PMI highlighted ongoing struggles in the manufacturing sector, raising concerns that these pressures could worsen in the coming months. Meanwhile, ISM Manufacturing data was mixed, with the Employment Index improving to 46.0 from 43.4, showing some resilience, but new orders fell to 44.6, the lowest since May 2023, signaling forward-looking weakness.

The August labor market report also came in mixed, with jobs rising to 142K from 114K but falling short of the 160K forecast. Unemployment ticked down to 4.2% from 4.3%, while average hourly earnings remained strong at 3.8% y/y and 0.4% m/m.

Initially, the US dollar sold off sharply due to the dovish interpretation of the report, and the odds of a 50bps rate cut surged to 57%. However, within an hour, markets reconsidered, questioning whether the headline miss and revisions justified a larger cut, especially given the slight improvement in unemployment. This sentiment shift was reinforced by Fed President John Williams, who took a cautious stance without advocating for a 50bps cut. Later, Fed Governor Christopher Waller’s remarks on possibly "front-loading" rate cuts briefly fueled optimism, but his comment that "the labor market is softening but not deteriorating" caused expectations for a 50bps cut to drop to 23%.

Looking ahead, markets will focus on the US August CPI, which could determine whether a 25bps or 50bps cut is more likely, given that the labor report wasn’t as weak as expected. Consensus estimates expect a +0.2% M/M rise in both headline and core inflation. Since the Fed is now more focused on the labor market than inflation, a slight uptick in CPI might not significantly affect expectations for a September rate cut. With much negativity already priced into the USD, an inflation print in line with expectations may not move the dollar sharply, allowing it to recover ahead of the Fed’s decision.

CAD: Economy under pressures

The CAD is set to remain under pressure in the near term due to several dovish signals from the Bank of Canada and ongoing economic weakness. The BoC recently delivered its third consecutive 25 basis point rate cut, bringing the overnight rate to 4.25%, and indicated that further easing could occur if inflation continues to slow. Despite slightly stronger-than-expected Q2 GDP growth, the Canadian economy showed signs of slowing over the summer months, particularly in the labor market, where unemployment has risen to 6.6%, the highest in over two years. Full-time employment dropped sharply in August, signaling further softness, which could weigh on consumer spending and overall growth.

Inflation is moderating, with headline figures nearing the BoC’s 2% target, but concerns remain over elevated shelter costs and service prices. Governor Macklem has emphasized a cautious, data-dependent approach to further rate cuts, noting the potential for additional easing if the economy weakens further. The market has priced in several more rate cuts over the coming year, increasing the likelihood that CAD will face further downward pressure.

In addition, political uncertainty in Canada, including the possibility of early elections, could also lead to increased volatility. Moreover, declining oil prices, driven by global supply concerns and slowing demand, are likely to weigh on CAD, as oil is a key Canadian export. Overall, the combination of domestic economic weakness, and dovish central bank policy suggests that CAD is likely to face continued downside pressure, particularly against the US dollar and other major currencies in the short term.