Global Rates & FX Views: Central banks & budgets
The desk posits that upcoming central bank decisions from the Fed, BoC, ECB, and BoJ will significantly influence global FX volatility, as these institutions contend with ongoing energy market uncertainty and pressures on risk assets. Per the full note, the discussions reflect a cautious approach amidst fluctuating economic conditions. Additionally, the imminent UK Budget is expected to provide further insights into fiscal strategies that could impact GBP dynamics. A watchful eye on emerging economic data and central bank signals will be crucial as these events unfold and market sentiment evolves.
What the desk is arguing
The desk emphasizes that upcoming central bank meetings will likely set a critical tone for FX markets, particularly as policymakers grapple with uncertainties linked to volatile energy prices and risk asset pressures. Per the full note, the Fed, ECB, BoC, and BoJ are each navigating distinct challenges while considering the implications for their monetary policies and economic outlooks.
Supporting evidence includes varying signals from central banks that indicate potential policy shifts. For instance, the discussions highlighted responses to energy market fluctuations and the effects of geopolitical tensions on economic stability, suggesting that traders should prepare for adjustments in interest rate expectations and related FX movements.
Where it sits in our coverage
Our current consolidated target for the EUR/USD pair sits at 1.075, within a range of 1.04 to 1.12, influenced by current macroeconomic indicators and central bank forecasts. Key firms have provided varying guidance with notable targets as follows: - JPMorgan: 1.10 (Mar26) - BofA: 1.04 (Mar26)
This outlook positions the desk's view aligned with the high end of the spread, reflecting heightened sensitivity to central bank communications and external economic developments.
How other firms see it
In the landscape of FX strategy, firms such as JPMorgan and Goldman Sachs maintain a broadly aligned outlook regarding the dovish stance of central banks, while BofA indicates a more cautious approach, suggesting potential weakness in currency pairs that may challenge current support levels.
Traders should closely monitor EUR/USD and USD/JPY for indications of how respective central banks' meetings will influence liquidity and risk appetite leading up to key decisions.
How firms align with this view
Aligned with the desk view
Contrary positioning
Key takeaways
- 01Upcoming central bank meetings are likely to create significant FX volatility.
- 02Ongoing energy market uncertainties are pressing policymakers into careful decision-making.
- 03The impending UK Budget could further impact GBP dynamics.
- 04Traders should prepare for potential shifts in market sentiment driven by central bank signals.
Market implications
Traders should watch the EUR/USD closely as it negotiates the upper range of 1.075, with upcoming central bank meetings serving as potential catalysts for directional moves. Additionally, market positioning ahead of the UK Budget could yield insights into GBP fluctuations.
Risks to this view
The current outlook could be invalidated by unexpected hawkish pivots from any of the central banks, particularly if economic indicators indicate stronger than anticipated growth or inflationary pressures, prompting a reassessment of interest rate trajectories.
Hello and welcome to Global Research Unlocked, the interest rates and FX series. This podcast is based on our weekly client conference call where our strategists along with guests from other parts of Bank of America Global Research discuss the most topical and pressing questions faced by our market. I'm Sfia Salim, Head of European Rates Strategy.
Today I'm very happy to be joined by representatives from our global economics team. We have Aditya Balve, who is Head of US Economics, Carlos Capistrán, Chief Economist for Mexico and Canada, Izumi Davalier, Head of Japan Economics, Sonali Punhani, UK Economist and Ruben Segura-Guevara, who is Head of Europe Economics. We'll talk about all the central bank meetings that we have next week, but also the situation in France in terms of how the ECB will approach it and the UK budget.
Before we start, let me remind you that any conflict disclosures related to securities discussed on this call can be found in the call invite. With that, let me start with you, Aditya, to cover the Fed. You have called brilliantly for the September hike.
Now you are very out of consensus in thinking they will hike again next week. Markets are pricing in less than 15% chance of that. What made you stick with this call?
Thank you, Sfia, and good morning, good afternoon, everyone. Thanks for joining this call. Our conviction is strong that the Fed should hike, and pretty low that the Fed will actually follow through and hike rates next week.
In terms of the normative case, they started hiking because they were concerned about trends in inflation, and although we got some minor downward revisions with methodological adjustments, the bigger story from our perspective is the very problematic September CPI trend. It was elevated in top-line numbers, but perhaps more importantly, the details were also very discouraging, so once you see that number, we think the Fed should go. Of course, the markets had already priced out an October hike before they saw that number because Williams and Jefferson, Williams is the head of the New York Fed, Jefferson is the vice chair of the Fed, of the Fed board, and they had both, before even seeing the September data, essentially signaled that the Fed doesn't want to go in October.
So this, from our perspective, is very heavy-handed forward guidance, and it raises the question of how you can square this with Walsh's dislike for forward guidance, either he's not being entirely, either he's not credible on that, or he didn't sign off on the message, and if he really wanted to end the era of forward guidance, he has a great opportunity here to push through a cut, and then going forward, the markets will be, sorry, a hike, not a cut, and then going forward, markets will be very hesitant to listen to the forward guidance from the Fed. However, if he doesn't, then he's a Fed chair who doesn't want to guide markets, who doesn't want to surprise markets, in which case, one would question what his role really is, right? Markets can set policy, or the rest of the Fed will set policy via the guidance, so I think he'll be in a tough spot.
Now, obviously, we acknowledge that it's a heavy lift for the Fed to deliver a hike when it's not in the price. They would be delivering a jolt to risk assets if they were to hike, and maybe given the wobbles in risk assets, they might not want to do that. So I think the main argument to not go is that it's not in the price, rather than, oh, they shouldn't go.
We're not really hearing that from clients. Very clear. So if they do not hike next week, what do you think their message will be?
I think it will be challenging, right? So Walsh will obviously be asked, why didn't you hike, and did you endorse the guidance from Williams and Jefferson? On the second one, again, he'll say, no, no, they're free to express their own opinions, and I don't think anyone is going to really challenge him and say, okay, well, then what's your role in all of this, if they've already determined policy for markets, right?
But on the first question of why he didn't hike, I think this is where he's going to have to tap dance a little bit, because he's going to have to say, look, we focus on trends, we don't focus on individual data points, and he might say something like, the trend didn't get worse, or the revisions were encouraging, or something like that. But look, it's a 35 basis point trend, yes, it's one month, but we've had several months like this just not so long ago, so how much weight do you want to put on two good inflation trends in June and July, which are already somewhat in the past, versus the more concerning news in the last two months, as well as in the year-over-year rate? And the risk is, he sounds complacent.
Markets were giving the Fed a pass in July as well, right? There were only 10 basis points hiked, but the complacency of his tone at the press conference is what caused that very unfavorable trade, which was questioning Fed credibility, steepening of the curve, dollar down, risk asset down, and that's the kind of thing he'll need to somehow try and avoid, and again, it's very difficult to do that without guidance. If he were willing to give guidance, he could say, look, we're pretty much set on going again in December, or we will continue to hike at a steady pace, and I think people will understand that as a quarterly pace of hikes, but that'll be the challenge for him.
Yes, talking about the path ahead, do you think that the moves now in equity markets affect that path, and what would be your scenario if they don't go next week? So, we should not miss the forest for the trees, right? There's minutiae around the timing of Fed hikes, and I'm really glad you asked that question, because big picture, the point is, they started hiking, and they're going to keep hiking.
We have 75 basis points for now, we would stick, let's say they don't go next week, then we would move the hikes to a quarterly pace, so instead of September, October, December, it would be September, December, March. I think the risks to the upside would increase a bit if they go slower, because they run a greater risk of falling behind the curve, and the equity market might spook them, right? There's also a little bit of concern kind of under the surface on credit, but all of this reveals to me an asymmetric reaction function, which will mean that the risks are greater that the Fed was more behind the curve, because remember, when equities were doing great, but the third year was pushing 5.7%, they said the long end is doing our work for us.
And now they're saying, look, we're in the middle of a risk-off trade, or I think that is what they're thinking, and they haven't explicitly said it, but we're in the middle of a risk-off trade, we don't want to cause another wobble in markets, okay, but the long end is rallied. Don't we must come back down? What about that?
Doesn't that mean you need to do more? And in isolation, you can say, okay, well, that's a silly argument, because this is a broader concern of AI and so on, but when you put that together with the idea that, oh, when rates are higher, that also means they should do less, then no matter what, you're arriving at the conclusion that they should do less, and I think that creates a risk that ultimately they fall behind the curve. But it wouldn't materially change our base case for now, if they don't go in October, we would just say, okay, still 75 basis points, just at a quarterly base.
Okay, thank you very much, Aditya, and now shifting to Carlos for the Bank of Canada, you are also going against markets there, but the other way around, so markets are pricing over 80% probability of a hike, and you think the Bank of Canada will hold. So why is that? Thank you, yeah, good morning, good afternoon, everyone.
Look, the market is convinced that the Bank of Canada is going to hike, but the economic case is really not, it's down to now, if you look at the economy, the economy remains weak, the output gap is negative, the last two labor reports have shown job contractions. Year to date, the job market has been contracting, so the economy is clearly weak, and then when you look at inflation, it is true that headline inflation is above the target, it's at 3.1%, but this is all because of energy prices, because when you look at core inflation, unlike the case in the U.S., core inflation in Canada is below the target, it's 1.9%. So you have a negative output gap, core inflation is below the target, why would you be hiking?
The case for hikes is because the inflation is above the target, oil prices remain high, the U.S.-Iran conflict continues, and this war is the central bank, so obviously they have been very hawkish, so they could actually hike. The piece of information that may have changed the balance is that on Monday, we got the results from the quarterly surveys that the Bank of Canada does, and in the consumer surveys, what we saw is inflation expectations move up, so the bank may be worried about that and may decide to hike because of that, but again, I think it's not a slam-dunk case from the economic perspective, so I think that actually the risk for that more than 80% that is priced in for the decision, it's actually that the Bank of Canada decides to surprise the market, remaining on hold, if they do remain on hold, they are going to continue to be hawkish because they are an inflation target in central bank, and inflation is above the target, but I think that they could remain on hold because of the economy, and because especially, because core inflation is below the target. Thank you on that, and so you're talking about them remaining hawkish, and the market has been quite stubborn in pricing, and not just one hike, but a string of hikes, now 100 basis points implied over the next 12 months, what do you think can change this bearishness on the front end?
So there are two things that can change that, one is very weak economic data, so I think the fourth quarter we're going to see a weak economy, remember that the trade war between the US and Canada escalated recently, we really have not seen any hard data from after the escalation, but even the data before the escalation, as I mentioned, has been weak, but I think the fourth quarter could be even weaker than what the Bank of Canada is expecting, so that's one. The second thing that can change market pricing is if inflation starts moving down, right, so this is not going to happen anytime soon, and the central bank, even if they remain on hold, the central bank is going to continue to be hawkish, so I think the market is going to continue to keep pricing hikes for some time, having said that, even if they hike, I don't see the case for a hiking cycle, I think that if they hike, at most they're going to do a couple of hikes just to position themselves a little bit better, and try to send the signal that they don't like the inflation expectations moving up, and that they are doing something about high headline inflation, so in any case, I have a high conviction that the market is pricing too many hikes for Canada, and I think that would remain even if they were to hike next week. Thank you, Carlos.
Now, shifting to Japan, Izumi, thank you for staying in this late hour. My pleasure. So, for next week, like consensus, you are looking for the BOJ to stay on hold, but we have the market pricing in a further 75 to 100 basis point of hikes in the coming year, so do you think the BOJ messaging next week will validate that pricing further out?
Yeah, so I think that the messaging at the meeting, whether that's through the outlook report, or Governor Ueda's post-meeting press conference, will support expectations for the next 25 basis point hike being in December, but I think that the BOJ will probably be reluctant to validate a specific terminal rate. So, first on the meeting itself, just want to remind everyone, we do expect that hold at 1.25%. We would be watching the number of dissents.
I think there's a high likelihood that we will get one hawkish dissent from Board Member Takata, who would probably propose a hike, but if it's 8-1, I don't think that's going to be a surprise. If we get more than one hawkish dissent, then that gets interesting. The key change in this meeting, in terms of the communications, is the Board is going to formally acknowledge that they think underlying inflation has reached the 2% target, but in their view, reaching the 2% target is not the same as having achieved the target, because now what they want to see is that underlying inflation stays at the 2% target on a sustained basis.
So, it really is about stabilization, which matters for the policy stance, because the Bank of Japan has been emphasizing concerns around upside inflation risks. Now that underlying inflation is at the target, they really can't tolerate any further overshoots. So, I think this will connect to the Governor's communications around the possibility of a December hike.
He's not going to explicitly commit to a move in December, but I think he will basically say things that will validate market expectations for such a move, including the fact that price pressures remain strong, growth is basically evolving in line with the BOJ's base case. But in terms of terminal, the BOJ's stance is that they really don't know where neutral is. It's probably not 1.25%, and they have been saying financial conditions are accommodative, but they don't have any preconceptions, whether it's 1.75% or 2% or even higher than that.
So given where the pricing is right now, I don't think they're necessarily going to push back in a dovish way, and obviously concerns around the yen haven't faded, but I don't think they're going to say anything hawkish that will cause a further repricing of hikes. Back to you. Thank you.
And more broadly, so thinking about the speed of the hikes and the path ahead, you flagged an interesting section in the latest BOJ financial system report. Today, it's on the resilience of firms to rising rates and the slow transmission of those rate hikes. So do you think this makes for more aggressive tightening?
Or on the other hand, it could actually make the BOJ more cautious because the transmission is slow, so maybe the effect will come later of what's been delivered already? Yeah, so it's a really good question. I definitely recommend anyone interested to read the report because it has a lot of good analysis.
On that, I do think it sort of validates the faster hiking pace, or more specifically, the quarterly hiking pace that we in markets are expecting for the time being. And I do also think that it supports a higher terminal rate at the margin, even though the argument there is less direct. So just to recap what the key points here are, so their analysis shows that if you look at Japanese corporates, a rising share is effectively debt-free, even amongst companies and particularly SMEs that tend to borrow, and things like interest rate coverage and debt ratios have actually improved thanks to the healthy economy.
So these stronger finances are helping absorb higher funding costs, and overall, there's a lot more buffers towards rising rates. One very interesting part of the analysis is that if you look at where the maturity of fixed rate borrowings cluster, they cluster around 2030 to 2031. The reason for this is because a lot of firms, particularly smaller enterprises, SMEs, borrowed at very long terms at extremely low rates during the COVID pandemic, where there were a variety of publicly supported borrowing programs.
So even amongst the most vulnerable borrowers, the reset comes a lot later. So this kind of connects to the BOJ's challenge. One thing that they've been grappling with is that, as I said, they now think underlying inflation is at the 2% target, but the pace at which underlying inflation has moved up has not been matched by the pace of removal of accommodation in financial conditions.
So overall, the fact that the transmission is slower, that firms have the buffer, I do think support the step up in the hiking pace. And on the margin, it does support a higher terminal, but you're absolutely right that just because the effects are delayed, it doesn't mean that they can just continue hiking. We do think that they will start to get more cautious as policy rate approaches 2%.
So it's more about, I think, the hiking pace in the near term, rather than the terminal for now. Perfect. Thank you very much, Yasumi.
Shifting now to Europe, since the ECB meeting, we did see quite a shift in the tone from ECB speakers, and they've been a bit more dovish. So do you think this shift makes sense, and do you expect Lagarde to indeed sound dovish next week? Hi, Shia, and thanks for inviting me.
Does it make sense? It does. And this is not, at least not mainly about France.
What we've seen is a very significant tightening of financial conditions, which accelerated after the September ECB meeting, with market pricing a very aggressive cycle, with long-term rates moving significantly higher. So it made sense to sound dovish, to try to regain some control of the narrative. Of course, you're not going to be explicit with forward guidance, but trying to regain some control made sense.
And thinking about next week, this is a backdrop of next week's meeting. The ECB is probably aware that if it is to be perceived as hawkish as it was in September, things could easily get out of control. And that, to me alone, provides enough incentives to lean on the side of some dovishness.
And I think that's what the ECB is likely to try to deliver. They can do it in several ways, but the simplest ones will be to put a lot more focus on the growth consequences of current developments relative to inflation than in previous meetings. And we have seen that from Laurent recently when she talked about long-term rates, when she tried to break that correlation between energy prices and policy rate pricing.
So I would expect a lot more of that. The other way, and I think this is very important, the other way they can lean dovish is on the mark of energy prices that have moved away from their baseline. I think it's important for Lagarde to reiterate that we are in a measured adjustment scenario, which I always read as a short hiking cycle of 75 Bps in total with some residual risk of 100 Bps.
Among all the central banks we discussed up until now, I mean, there was in general talk of several more hikes potentially still being priced in by markets. But with this shift in ECB tone, some are raising the question whether ECB may be done here and maybe a December hike may no longer be on the table. What do you think of that?
It's not unthinkable. Look, it's very easy to hide on the fear of second round effects, which is what the ECB is doing, when the economy is quote-unquote resilient, and I say quote-unquote because to me resilient is a new keyword for mediocre growth. But if you start to see slightly weaker growth and you see something is about to break, then you are not in such comfortable place in which you can continue chasing goals and keep hiking on the fear of something that never happens.
So if on the run up to December we see activity data deteriorating quite a bit or we see a couple of bad bank lending surveys and energy prices do not go a lot higher from here and you're still not seeing second round effects or a strong indirect effect, I think there is an opportunity for them to skip December and actually to stop the hiking cycles. I wouldn't make it my base case, but I wouldn't put it at zero probability either. Now to the big question around fringe spreads.
Do you think that them stopping the hike here is what needs to be done to address the widening in the fringe spreads or do you expect any different intervention from them? Also the big question we're getting, is there a specific level at which do you think the ECB will intervene? I mean, the pain threshold is not here and I always remind of the same with BTPs at 250 spread, the ECB did not intervene.
It's not only about the level, it's also about the speed. The point I would make is that if the ECB does something initially, it might not be about fringe spreads, but it's about financial conditions once again. And that's the third channel in which they could be dovish next week, not in terms of action, but in terms of variable intervention.
The market moves we've seen in the last few days, if we continue seeing this volatility, they might need to do a bit more to regain some control of the narrative and more importantly, to avoid something breaking down the line. So they can potentially talk about two things and they are not mutually exclusive. We could get both.
I think next week, like I could flag that some of the market moves do not seem fully justified by fundamentals and then she can remind us that they have tools to address this type of development. But second, and I think this one is more important, there's been plenty of discussion on whether the ECB will change QT soon. I don't think they are going to touch it structurally.
They really believe this can continue going forever and ever and then you have the structural portfolio down the line leading to organic policy growth. But what they could do is to flag that if things remain volatile and somewhat disorderly, the ECB could take a temporary pause on QT until market conditions normalise. So I think that's the two things we could hear from the ECB next week.
To your question, would the ECB stop hiking if it's only about French spreads? I doubt it. That's what TPI is for, when you hit the pain threshold to trigger TPI.
But if the move in French spread is driven by a broader tightening of financial conditions, then yes, that could be another factor in the run-up to December. Great, thank you Ruben. Finally, Solange, on the UK.
It's interesting that the rally in gilts this week contrasts very much with the sell-off we've seen in France in periphery bonds. It seems as though markets are at ease with the budgetary risks in the UK and comfortable again in considering gilts as a safe haven asset in the current environment. Would you say it makes sense for the market to be this comfortable on budgetary elements heading into next week's budget presentation?
Thanks, Clea, and thanks for inviting me, and good morning and good afternoon, everyone. I think heading into just next week's budget specifically, to me, this makes sense. Obviously, we've seen fiscal events in the UK have been many a times a source of volatility, but this year's budget, we think, is going to be quite different from that.
We expect it to be a fairly low-key event and the government mainly delivering a fairly cautious autumn budget given the fragile bond market. I think the government is aware of the risks that this budget holds, especially given the fragility of the global scenario, and they do worry that if they don't deliver a cautious budget next week, then it does increase risks that the UK's position at the current safe haven asset could be in jeopardy. I think next week, in particular, we think the fiscal rules are going to be met.
They've said it many, many times that fiscal discipline is the bedrock of stability, so I think that tone is likely to continue. We don't even expect any carve-outs or exclusions from the fiscal rules. So, fairly straightforward there.
We do think some flexibility could be used to increase spending on investment in a fairly limited manner via public financial institutions. I think this is something that has been discussed quite a few times. So, as long as this is fairly limited, i.e., say, $3 billion a year or something, I think the markets would be able to absorb that.
Obviously, the risk is that if they use this flexibility in a more gracious manner and lead to higher gilt issuance, that could be something the markets wouldn't like. But overall, we don't expect that. We expect that if they use this flexibility, it's fairly limited.
Clearly, the pre-measures headroom is likely to be deteriorated to $10 billion, is our expectation, but we do think that the government will do correct its fiscal policy to partially restore that post – that headroom to $17 billion. So, we do expect $8 billion of tax rises, whether it's via banks or gambling levies, et cetera, to be announced in order to kind of restore this post-measures headroom. The budget will also contain some near-term giveaways to ease somewhat the inflationary pressures from energy.
But again, that's good news because if it does lead to lower inflation, that's something that OECD is going to be slightly encouraging for the Bank of England. So, net-net, we could potentially get a slight increase in borrowing, and even the gross financing requirements for the current fiscal year could be topped up by $10 billion. But as you know, our UK rate strategist is expecting the additional funding requirement to be met via higher net T-bill sales, which, if at all, should be bullish for gilts.
So, net-net, again, a benign budget for next week. But for us, that doesn't mean that fiscal challenges have gone away from the UK. Next week, a lot of the big spending ambitions of the new government, like defense, social care, unprotected department spending, et cetera, that would not be addressed.
And I guess that is where the risk is. It's not what the budget has, but what the budget does not – will not have. That means that these big ambitions are likely to be pushed to later years, but that doesn't mean that they've gone away.
Next year's spending review and next year's budget are going to be the key moments where these tough fiscal realities would eventually need to be confronted. Perfect. We'll focus on next week for now.
But we also have the BOE, not next week, but the week after, and you are expecting a hike. Do you think the recent data still supports that call? And what do you expect the BOE's overall message to be?
Yeah. So, we are expecting a hike in November, followed by a second hike in February. The recent data for us does strengthen the call for the case for the Bank of England now finally starting to hike.
Firstly, the inflation data just keeps surprising the Bank of England's forecast to the upside. Now, we do admit that most of the surprise relative to the Bank of England has been driven by energy, but underlying services inflation also remains uncomfortably high. All this while, we were seeing some disinflation in underlying services inflation, which the Bank of England was saying is countering upside inflation risks from energy.
But that doesn't seem to be the case anymore. I mean, the last couple of prints have seen a tentative pickup in underlying core services inflation, and that to me means that domestic disinflation has basically stalled. But more importantly, the labor market, which is, again, one of those things that the Bank has made the Bank of England a bit dovish all this while, that labor market data looks to be stabilizing.
We see slightly rising payrolls, falling unemployment, which means that the labor market is potentially at the cusp of bottoming out. And this follows mainly stronger than expected GDP data that we've been seeing this morning. The PMIs were pretty good as well.
And it shows that the economy continues to be a bit resilient, and it's faring better than expected in the middle of rising energy prices. And that's mainly because AR-related investments and activities are helping the UK economy buffer the shock from the conflict. So at the very minimum, this stronger than expected economy does reduce the trade-off for the Bank of England between growth and inflation and allow them to focus more meaningfully on upside inflation risks.
But also, there's increased the risk that the firms pass through this energy shock more meaningfully. So adding this all up with rising energy prices and inflation set to top 4% in early 2027, this clearly calls for action in our view from the Bank of England in November. But we do think that the messaging is going to be fairly balanced.
I mean, they deliver the hike, but we think the message would be fairly balanced, keeping the hiking bias alive, but pushing back against the need for an aggressive and sustained hiking cycle. I think while data is looking strong, the usual arguments on second round effects have been that the data has pointing to fairly limited second round effects from the conflict. And like last time, Bailey could say that market pricing reflects some risk premia, that they didn't discuss 100 bps of hikes, et cetera, et cetera.
And we've seen that even the most hawkish member, Pill, has pushed back against market pricing of close to four hikes, calling it fairly excessive. So it's likely to be that, you know, look, we are in a risk management insurance mode, you know, setting the stage for a small and gradual hiking cycle. But it may say that, you know, I think to materialize the market pricing of more than four hikes, we would really need to see those concrete evidence of that strong second round effect actually materializing, not just the risk of it, but actual evidence that it is showing up in the data and also a very, very persistent energy shock similar to what the NTC had in the adverse scenario, which in our view is not obvious case for now.
Great. Thank you, Sonali, and thank you, everyone. Thank you for joining us today.
We hope you found this useful and that you'll tune in next week.
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