The third quarter closed with the world economy looking more resilient than it has any right to look. The wars in Iran and Ukraine continue. Energy markets have been disrupted. Food prices are broadly rising again. Central banks have resumed tightening.
Yet, the high-income economies have not buckled. Despite the US tariff provocations, most countries have not retaliated. The downward spiral that followed Smoot-Hawley has not materialized. Countries are muddling though the pace of the interest rate adjustment is unsettling. Many observers thought Japan was the weak link, but instead the strain in France is palpable with knock-on effects on other peripheral European markets, like Italy, and arguably a drag on the euro.
Resilience
The immediate issue for businesses and investors is not recession. It is the persistence of inflation, the policy response to it, and the extent to which capital spending, especially on artificial intelligence, can continue to offset the drag from higher real interest rates and geopolitical fragmentation.
The US economy has surprised on the upside. The Atlanta Fed’s GDPNow tracker puts Q3 growth at 3.7%. It is not official forecast. Still, it captures the essential point. US growth is running materially faster than the consensus had expected only a few months ago, arguably helped by a budget deficit the Congressional Budget Office estimates to be 5.8% of GDP and a consumer whose confidence is poor but continues to shop.
The strength is uneven. Consumption remains supported by employment, income, and asset prices. Fiscal policy remains more stimulative than many assume. But the investment impulse is increasingly concentrated. AI-related spending is the conspicuous driver. It is lifting orders for chips, servers, networking equipment, power equipment, construction, and data-center capacity. The narrowness of the investment boom and the circulatory financing (e.g., producer-financed sales) is a vulnerability.
AI
By a broad measure of information-processing equipment, data centers, and software investment suggest AI accounts for almost half of US growth requires over the past several quarters. qualification. However, this may overstate the case. A narrower calculation that adjusts for imported computers, peripherals, and semiconductors makes the contribution closer to a third.
Still, the direction of travel is clear. The US expansion is increasingly dependent on capital-intensive investment in computing infrastructure, and on the wealth, effects generated by the equity market’s enthusiasm for it. This is an investment boom that uses electricity, concrete, copper, turbines, transformers, memory, chips, and skilled labor. It is not merely an exercise in software valuation.
Nor is it only an American story. Taiwan’s July export orders rose 61.9% from a year earlier, led by information and communication technology orders, which jumped 89.5%. Machinery orders rose 31.3%, while orders from the US increased nearly 89%. This is the AI cycle showing up in the real economy and in cross-border trade. China’s machinery trade has also been strong, approaching $700 billion, while its industrial firms continue to move up the value chain despite export controls, weak domestic property markets, and trade frictions.
Japan participates from another angle. Its exporters supply capital goods, precision components, factory automation, and materials. The important point is not that Japan is becoming the center of the AI boom. It is that global investment demand is providing a source of external support at a time when domestic Japanese demand remains uneven.
Monetary Policy
The third quarter ended with rate hikes by the Federal Reserve, European Central Bank, and Bank of Japan. The ECB had already delivered a 25 bp increase, lifting its deposit rate to 2.50%, and explicitly linked the move to the Middle East conflict’s effect on prices and to inflation remaining above target for an extended period. Despite uneven growth, and inflation which has not been above target this year, the Bank of Japan lifted is overnight rate target to 1.25%. It was also its second hike of the year.
After sounding hawkish but not advocating a rate hike, Fed Chair Warsh came under increasing pressure following the stronger than expected August job growth and what still appeared to be sticky price pressures. The US two-year premium over Fed funds has widened to over 90 bp the most since 2022, when the Fed was engaged in the most aggressive tightening cycle in decades. It ultimately proved untenable for a Chair who suggested that the bond market was the smartest economist. With a unanimous decision, the Fed hiked rates in September.
The ECB, the BOJ, and the Federal Reserve will likely hike again in the fourth quarter. The Fed faces stronger activity, sticky inflation, and an economy not behaving as if monetary policy is restrictive. The ECB faces the same energy-price shock with weaker underlying growth, which makes its task more difficult rather than easier. The BOJ is caught between inflation, a still-vulnerable currency, and the risk that additional tightening damages a fragile domestic recovery. The Bank of England may join the tightening cycle, especially if services inflation and wage pressures do not ease. The Bank of Canada is also likely to hike in Q4, even though October is a close call.
China’s economic growth continues to disappoint, while is trade surplus in high-tech sector brings new trade frictions. And despite the widening of China’s discount to US Treasuries, the Beijing has continued to endorse gradual appreciation of the yuan. The yuan is at its best level since early 2022. Recognizing the disappointing growth prospects, at the end of September, Beijing announced a series of modest initiatives, including mortgage subsidies, and expanded central bank support for key sectors.
Broader Challenge
For many high-income countries and businesses there are five major disruptions: Russia’s war on Ukraine, the US war on Iran, the US tariffs, China’s export penetration, and AI. They are taking place as the old order, which, for most part, accepted the post-WWII borders, is fragmenting and being challenged. There was more or less free navigation of the seas.
Whether it was the General Agreement on Trade and Tariffs, or its successor, the World Trade Organization there were rules of trade. Of course, as in sports, the violation of the rules was part of the game. Yet there were rules and now, well, it seems like there is none but national self-interest.
Ian Bremmer’s 2012 book, the G=Zero World declared that no country or group of countries could provide those public goods, like international security, financial stability, freedom of navigation, open global trade, and nuclear non-proliferation. While it may not have been a good description of the time, it certainly resonates more now.
Bannockburn World Currency Index
Bannockburn's World Currency Index is composed of the currencies of the dozen largest economies--half of which are from high-income countries and half from emerging markets. It fell in September for the first time in three months, reflecting the weakness of most of the components. The nearly 0.4% decline offset the August gain in full. BWCI is up about 0.65% this year after a 3.7% advance last year, which was the first increase since 2020. Broadly speaking, BWCI has chopped in a range so far this year between about 90.85 and 92.45. It tested the upper end of the range in the first part of September and has traded with heavier bias over the past few weeks. It finished September slightly below 91.75.
All of the G10 components fell against the dollar in September, but the Japanese yen. The threat of intervention and speculation that Japanese assets managers, like pension funds and life insurance companies, would repatriate capital, in the higher Japanese interest rate environment, support the yen. It appreciated by almost 1.5% against the dollar in September. The Australian dollar lost a little more than 3% against the greenback. The Canadian dollar and euro fell by about 2.65% and 2.50%, respectively. Sterling depreciated by a little more than 2%. These currencies make up about a third of the BWCI. The dollar also accounts for about a third of our GDP-weighted index.
Emerging market economy currencies fared somewhat better collectively. The Chinese yuan, which accounts for almost 21% of the BCWI rose by an insignificant 0.20% in September. The roughly 3.15% rise in the Russian rouble was the strongest component in September, but its contribution was more than offset by the 5.95% decline in the Mexican peso. The rouble has a 2.75% weight, while the peso's weight is slightly less than 2%. The Indian rupee fell by 0.70% and accounts for 4.25% of the BWCI. The Brazilian real (2.44% weight) and the South Korean won (2.01% weight) rose 0.20% and about 0.85%, respectively.
U.S. Dollar: The dollar's rally last month began before the Federal Reserve delivered a 25 bp hike on September 16. The market was unpersuaded by the median projection in the Summary of Economic Projections, which pointed to an unusually short tightening cycle. At the peak, visited several times in September, the Fed funds futures implied strong confidence in four rate hikes by the end of next year. Yet, the pendulum of expectations swung too far, and a combination of comments from the Vice Chair of the Federal Reserve Board and the Vice Chair of the FOMC and disappointing September employment data spurred a reconsideration. The futures market downgraded the likelihood of a rate hike this month to about a 25% chance from 70% as recently as September 28. The most important data point ahead of the October 27-28 FOMC meeting may be the September CPI on October 14. A 0.3% rise would leave the year-over-year headline pace at 3.4% and could see the core rate tick up to 2.5% from 2.4%. The Atlanta Fed's GDP tracker sees puts Q3 growth at 3.7% as of October 1. It is likely to be among strongest economies, suggesting the US may still be in the best position to weather the shocks, some of which may be self-inflicted. On balance, given the reduced interest rate support and the stretched technical indicators, our bias is for a consolidative to weaker dollar in the coming weeks.
Euro: The eurozone faces several disruptions, and the euro which is near the year's trough is paying the price. The energy shock does Europe no favor. As the ECB recognizes it generates upside risks for inflation and downside risks for growth. European officials have still not managed to check the import surge from China, and it does not appear to have the leverage to encourage a "voluntary restriction on exports". The US continues to threaten more tariffs, and the next round could be for "excess capacity". Although the ECB has hiked twice this year compared with one move by the Federal Reserve, the derivatives market has more Fed tightening than the ECB over the next 12 months, and the US two-year premium over Germany widened by more than 25 bp over the past three weeks. It is approaching the year high set early July near 167 bp. The governments in France and Germany are unpopular, and this weakens European leadership. French President Macron's term is up in April, and German Chancellor Merz is barely hanging on. It will be clearer in the coming week or so whether the AfD can be kept out of government in Saxony Anhalt. ECB President Lagarde has signaled she will step down before October 2027. Speculation of her competing for the French presidency has diminished, and many expect to her go to the World Economic Forum.
(As of October 2, indicative closing prices, previous in parentheses)
Spot: $1.1255 ($1.1585) Median Bloomberg One-month forecast: $1.1380 ($1.1599) One-month forward: $1.1270 ($1.1600) One-month implied vol: 6.5% (5.4%)
Japanese Yen: September was a month of two halves for the yen. The intervention in late July/early August was challenged as August progressed and the dollar reached JPY160.40 on September 3 before rate hike speculation and that yen-carry trades were being unwound. The dollar was sold aggressively and fell through JPY155 for the first time since February. It briefly slipped below JPY153 on September 9 before trending back to JPY159 two weeks later, despite the BOJ's rate hike and signal that additional tightening will likely be necessary. The rate hike was well discounted, and the greenback rallied from about JPY156 to JPY159 after BOJ's announcement. Contrary to both theory and conventional wisdom, the dollar-yen exchange rate is more correlated with changes in US rates than Japanese raters of the interest rate differential. Over the past 30 sessions, the exchange rate and the changes in the US two-year yield have a correlation of almost 0.60. The correlation with the US 10-year yield is around 0.95. Turning to Japanese yields, the correlation of changes in the exchange rate and Japan's two-year yield is negligible at -0.04. The correlation with the 10-year JGB is a little more than 0.30, which means that higher Japanese 10-year rates tend to be associated with a firmer US dollar. The correlation between the exchange rate and the interest rate differentials are around 0.55. A key takeaway is that officials will find it difficult to hold the dollar back during periods of rising US yields.
Spot: JPY157.85 (JPY160.09) Median Bloomberg One-month forecast: JPY157.00 (JPY159.07) One-month forward: JPY157.45 (JPY159.72). One-month implied vol: 9.1% (7.0%).
British Pound: We suspect sterling is ending its third multi-week decline of the year. The was nearly a 5.2% swoon from late January through the end of Q1. The second was from mid-May through late June and it took sterling down about 3.75%. The third began in late August through late September. It was a little less than a 3.5% decline. We look for sterling to recover into the $1.3400-50 area in the coming weeks. The Bank of England stood pat in September but seemed to signal a hike was coming, and the swaps market has a little more than an 85% chance that it will be delivered at the next meeting in early November. Between now and the end of Q2 27, the swaps market has about 100 bp of tightening discounted, which seems aggressive. The October 28 presentation of the budget by Chancellor Healey will be the first opportunity for the new Labour government to showcase its fiscal priorities. Given the rise in borrowing this year, due in no small part to rising prices, and greater debt servicing costs, there is little room to maneuver. Prime Minister Burnham is likely backing a small down payment of his larger vision with a selected increase in taxes and a small increase in targeted spending. In his party address, Burnham offered a critical assessment of Brexit and unambiguously more pro-EU vision than had been previously endorsed. The UK does not have to hold elections until August 2029, but Burnham seems to recognize he needs a mandate and there is speculation of an election next year.
Spot: $1.3240 ($1.3538) Median Bloomberg One-month forecast: $1.3300 ($1.3408) One-month forward: $1.3245 ($1.3540) One-month implied vol: 6.4% (5.6%)
Canadian Dollar: The Canadian dollar fell by a little more than 2% in September. It was weighed down by the broad strength of the US dollar and the widening of Canada's interest rate discount to the US. Canada's two-year discount reached approached the 28-year high seen last year near 155 bp. Canada's discount on 10-year yields reached about 120 bp, the most since May 2025. The divergence of the policy rate is the most since early the early 2000s and the pricing of in the swaps market suggest it may begin narrowing early next year. The market is discounting a little more than a 50% chance of a hike by the Bank of Canada at meeting in late October, and three hikes are nearly fully priced in by the end of Q1 27. Prime Minister Carney's is combining privatization, with state help for companies negatively impacted by trade tensions with the US, drawing closer trade ties with others, including the European Union. He enjoys strong domestic support. That, coupled strengthening nationalism, may be sufficient to encourage Alberta voters on October 19 to refrain from initiating a process that could lead to a new referendum on leaving Canada.
Spot: CAD1.4250 (CAD 1.3905) Median Bloomberg One-month forecast: CAD1.4120 (CAD1.3994) One-month forward: CAD1.4230 (CAD1.3888) One-month implied vol: 4.4% (4.3%)
Australian Dollar: The Reserve Bank of Australia delivered its fourth rate hike of the year in late September. Its 4.60% cash rate target is the highest since 2011 and stands atop the G10. The central bank may not be finished. The futures market has about a 40% chance of another hike before the year is out. August inflation rose to 4.0% (from 3.5% in July) and is now the highest since April. Still, the tightening of monetary policy appears to be adversely impacting the housing market. The unemployment rate has also risen from 4.1% in January to 4.6% in August, the highest since October 2021. Meanwhile, despite the rise in commodity prices, Australia goods trade balance has deteriorated this year. In the first eight months of the year, Australia's trade surplus has narrowed to an average of about A$1.3 bln a month, down from an average of $4.06 bln a month the first eight months of 2025 and $6.1 bln January-August 2024. In late September, the Australian dollar tested support near $0.7000. A convincing break targets the $0.6920-40 area.
Spot: $0.6955 ($0.7019) Median Bloomberg One-month forecast: $0.7010 ($0.7104) One-month forward: $0.6950 ($0.7015) One-month implied vol: 8.0% (7.3%)
Mexican Peso: The jump in US rates and sharp appreciation of the dollar spurred an unwinding of carry trades in a way that the yen's surge in late July/early August and again in early September did not. Some of the yen's funding role appeared to have been shifted to the Swiss franc and US dollar. High yielding emerging market currencies suffered in September, and the Mexican peso was the weakest in that universe, losing nearly 4%. The dollar reached above MXN17.70 for the first time since April. The market is stretched and we will look for some kind of technical sign that a top may be in place. Still, the next upside technical target may be around MXN17.85. While the domestic economy is fragile, the external account is solid. In the first eight months of the year, the average monthly trade surplus averaged $1.32 bln a month compared with $168 mln a month in Jan-July 2025. Worker remittances averaged about $5.17 bln a month through August this year, slightly more than the average in the first eight months of last year (~$4.97 bln).
Spot: MXN18.1635 (MXN17.0360) Median Bloomberg One-month forecast: MXN17.8470 (MXN17.2680) One-month forward: MXN18.2040 (MXN17.0765) One-month implied vol: 12.1 (6.3%)
Chinese Yuan: Chinese officials used the setting of the daily reference rate to signal the acceptance of a gradually appreciating yuan. The 0.2% rise in September seems to be small beer and inconsequential. The year-to-date rise of 4.2% makes it among the strongest currencies this year, but given China's competitive advantages, it is likely too small to impact the large trade surplus. Meanwhile, economic activity has continued to disappoint, and the Bloomberg's economic data surprise index is near a five-year low. Beijing has not provided fresh monetary or fiscal support for the flagging economy. The 10-year yield is hovering new record lows (below 1.70%). The new support measures announced seem too modest to have much impact but could be an accelerant if the September PMIs are signaling a cyclical upswing. The US-China tariff truce was extended for two months, until January 10, while officials work toward a potentially larger agreement. The next key date for the US-China talks is the APEC meeting in Shenzhen November 18-19. On September 24, following the quarterly meeting, the PBOC's statement warned that it will "prevent the 'herd effect' and the self-reinforcement of irrational expectations" in the foreign exchange market. Still, the central bank continued to lower the dollar's reference rate to new lows since early 2022.
Spot: CNY6.7060 (CNY6.7290) Median Bloomberg One-month forecast: CNY6.7085 (CNY6.7494) One-month forward: CNY6.7265 (CNY6.7650) One-month implied vol: 2.3% (2.4%)
Reviewed by Marc Chandler
on
October 03, 2026
Rating:
