Volatility awakens: The Dollar’s summer slump turns stormy

The dollar limped into the weekend, sagging back toward recent lows after briefly catching some haven gusts when bond markets cracked earlier in the week. For those who were hoping for EUR/USD to tag 1.18, the move stalled shy, but the direction of travel is unmistakable: the Fed’s looming shift toward heavier easing has pulled short-end U.S. yields down to year-to-date lows, eroding the greenback’s spine.

The August nonfarm payrolls report only deepened the wound. Not only did the headline underwhelm, but downward revisions showed June employment actually contracted by 13k. That kind of retroactive rot is the stuff that cements expectations for jumbo rate cuts, and traders are now openly gaming whether September could bring not just 25bps, but another jumbo 50bps cut—an echo of last year’s September surprise. The ECB, by contrast, is on hold next week, and that simple divergence in momentum—Fed easing versus ECB stability—hands the euro a tailwind even as French politics heat up.

If there’s a nagging issue, it’s that dollar bears are already shoulder-to-shoulder. Ask around the market: who is long USD here? You’ll hear crickets. That doesn’t mean the dollar can’t grind lower, but it does mean every dip runs the risk of short-covering squeezes when yields twitch or safe-haven narratives flare. Indeed, the earlier sell-off in European and Japanese long bonds rattled nerves enough to briefly inflate the dollar, before easing expectations drowned it again.

Behind the yield move lurks politics. President Trump’s decision to fire Fed Governor Lisa Cook has thrown the institution’s independence into question. Legal battles will decide whether he even has the power to do so, but in the meantime, the market has drawn the obvious conclusion: the White House has its hands ever deeper in Fed policy. With Stephen Miran expected to become the third Trump-appointed governor this month, and Powell’s chairmanship ending in May, the personnel drift is all one way—toward a Fed more pliant to the administration’s desire for easier money into the midterms. The dollar outlook has accordingly been revised lower; institutional independence matters, and markets are discounting its erosion.

Typically, a drop in U.S. short-end yields and a spike in volatility would supercharge the yen. Not this time. JGB yields surged instead, a function of renewed domestic political risk. PM Ishiba’s grip is shaky after the LDP’s loss in the Upper House, and talk of an early leadership election is gaining steam. Ishiba has threatened to dissolve the House if forced, but many in his own coalition balk at the gamble. That instability has kept the yen muted even as U.S. yields sag, and may delay the BoJ’s next hike—once expected in October—into year-end. Ironically, Trump’s tariff cut on Japanese autos should cushion the economy, but the political uncertainty overshadows the fundamentals. For now, the yen’s best near-term outcome would simply be Ishiba clinging to power long enough to let the BoJ act.

Across the Channel, France faces its own political stress test. Bayrou’s government will almost certainly lose Monday’s confidence vote, forcing Macron to appoint yet another prime minister—the fifth of his second term. But while messy, markets are unlikely to punish the euro too much. ECB forecasts are expected to show modest upgrades to growth and inflation, validating a second consecutive “on hold” stance. The hurdle for further cuts remains high, especially with inflation still sticky around 2%. Policy divergence with the Fed remains the dominant axis: ECB steady, Fed cutting.

Beyond FX, the week’s true tremor came from the long end of bond markets. U.K. gilts hit 27-year yield highs on budget jitters, ultra-long JGBs touched records, and even U.S. Treasuries wobbled. There wasn’t one spark, but the dry brush was everywhere—tax hikes, fiscal strains, leadership doubts. The Friday rally owed to a modest +22k jobs surprise, but the scars remain. Traders are nervously eyeing the U.S. benchmark payroll revisions due Tuesday, where the QCEW suggests as many as 750k fewer jobs in 2024 than previously reported. If confirmed, that would prompt the market to punch its 50 bp cut ticket in September.

This has been a dull summer in FX, but the trees are starting to rattle. The Fed is wobbling, politics are encroaching, and volatility is stirring. The grind lower in the dollar may not be explosive, but it’s real—and as every seasoned trader knows, grinds can be just as lucrative, if not more so, than the fireworks.