Global Rates & FX Views: Central banks – the aftermath
Lead — As central banks navigate turbulence in the current economic landscape, market participants are keenly watching the implications of this week's pivotal Fed, BoE, and BoJ meetings. Per the full note from BofA Global Research, uncertainties surrounding the Fed's decision-making process signal potential volatility in 2y and 10y UST yields, impacting major FX pairs including EUR/USD, GBP/USD, and USD/JPY. The consensus across various firms anticipates a moderate uptick in the EUR/USD and GBP/USD pairs while the USD/JPY reflects a more bearish sentiment with targets as low as 150 in the Dec-26 horizon. With no major calendar events on the immediate horizon, investors are left to gauge sentiment and positioning amid this backdrop of uncertainty.
What the desk is arguing
The desk frames this as a critical juncture for currency markets given the uncertain outcomes from central banks this week. The Fed's cautious stance and the diverging paths of the BoE and BoJ have led to mixed signals in the rates space, which could materially affect the volatility and directionality of FX pairs.
BofA highlights that the market's focus is on yield movements, particularly for 2-year and 10-year UST yields, given that these are intrinsically linked to the relative attractiveness of USD-denominated assets. With discussions surrounding EUR/USD potentially targeting levels towards 1.1700 in Mar26, there’s considerable room for fluctuation based on economic sentiment and central bank rhetoric going forward.
Where it sits in our coverage
Current consensus for EUR/USD stands at 1.1700, within a range of 1.1200–1.2000. Notable targets by firms include: - Deutschebank: Mar26 at 1.1800 - Morgan Stanley: Mar26 at 1.2000 - Commerzbank: Mar26 at 1.1900
This view aligns with our internal coverage where we see EUR/USD targets underscoring a bullish outlook, particularly when juxtaposed against BofA's more conservative guidance at 1.1700, positioned near the median target with expected volatility ahead.
How other firms see it
Several aligned firms, including Deutschebank and Morgan Stanley, are forecasting a strengthening EUR/USD towards 1.1800 and above, suggesting a shared optimism among some market participants about the Euro's resilience and the dollar's challenges. Conversely, Citi and Rabobank present a more cautious outlook with targets reflecting potential downside.
As the market engages with central bank discourse, the EUR/USD trajectory appears closely tied to the Fed's impending rate moves and guidance, indicating that shifts in sentiment here will resonate strongly across related pairs like GBP/USD and USD/JPY, both of which are also under the influence of respective central bank shifts.
01The Fed's cautious approach signals potential volatility in FX pairs as it impacts UST yields.
02Current consensus targets suggest a bullish sentiment for EUR/USD and GBP/USD in the medium term.
03Market participants should focus on central bank advancements as they pose pivotal influence over currency movements.
04Yield differentials remain a key driver of currency valuation as economic metrics unfold.
Market implications
Watch for potential fluctuations in EUR/USD, particularly as it hovers near the 1.1700 mark, while positioning strategies may need to account for significant shifts in UST yields influencing dollar strength. The relative performance of GBP/USD is also of interest as the BoE's stance evolves.
Risks to this view
Key risks include a hawkish pivot from the Fed that could contradict market positioning, leading to sharper corrections in EUR/USD and GBP/USD. Furthermore, unexpected economic data releases could alter the trajectory of the dollar’s performance and provoke a re-evaluation of consensus targets.
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 Zviya Salim, co-head of Global Rates Strategy.
That's Friday, July 31st, and today we'll present you with our key takeaways on the major central bank meetings that took place this week. We will also discuss the implications for rates markets. I'm pleased to be joined by Izumi Devalier, head of Japan Economics, Agnieszka Tengarity, UK rates strategist, and Bruno Brezina, US rates strategist.
Izumi, let's start with you on the BOJ today. It was a very anticipated meeting from a guidance perspective. The JGB curve flattened at the margin, signaling a mild hawkish interpretation.
So is that a fair assessment of the messaging, in your opinion? Yeah, thanks, Zviya, and thanks everyone for joining the call. So I think that is a broadly fair characterization of what happened.
The key changes today was not the BOJ's forecasts themselves, which were fairly mixed and mostly mechanical, but I think the language around the risks and the policy outlook, and here the communication skewed hawkish. So basically the message that the Bank of Japan has been trying to reinforce for several meetings now is that Japan's underlying inflation is no longer far from the 2% target. And in fact, we have some policy board members who argue that it's already at the 2% target.
And I think today's communications took that a step further. So in this latest outlook report, the Bank of Japan formally incorporated concerns about underlying inflation overshooting 2%. And in his post-meeting press conference, Governor Ueda also stated that underlying inflation is now quite close to 2%, so he also strengthened the language there.
At the same time, the BOJ does continue to characterize financial conditions as accommodative. And meanwhile, the list of factors that could affect prices continues to build in an upside direction. In fact, in the July outlook report, the BOJ explicitly added AI-related demand and FX developments to the list of risks it is monitoring alongside developments in the Middle East.
So I think there's just much more vigilance for upside inflation risks, and that opens up the path for the Bank of Japan to justify a hike on basically risk management grounds. Another point I would mention is that Governor Ueda was careful to keep the September meeting live. But one thing I would say is that he did not send a strong signal that the policy board was leaning towards September either, which is why I think the repricing was not dramatic.
Generally, this was a hawkish meeting, but nothing definitive on September. Thank you, Jumi. You also published a report today post-Tokyo CPI, and again, emphasizing that this inflation trend has largely run its course also.
So based on that and what you just mentioned about the change in BOJ's language around inflation risks, why do you think they're not being more forceful and explicit here about the coming hike or the pace of the hikes going forward? Yeah, so I think a simple reason is that, first of all, for them, again, the path where they justify a hike based on FX developments or etc. is really kind of a path where they're really responding to renewed risk scenario of underlying inflation overshooting 2%. That is not their base case.
So in their baseline scenario, October is probably a more comfortable timing for them because the BOJ will have three important additional pieces of information to justify an additional hike. So the first one is that they will have a much clearer read on the developments around price hikes in September and October, which they've flagged as a very important checkpoint for the next rate hike. Second, they will have another round of inflation expectations data, including from the Tonkin and the Household Opinion Survey, which would help them assess whether the recent continued rise in inflation expectations was affected by developments around the Middle East or therefore, you know, is it temporary or is it going to stick?
And third, it will have more evidence to see how its previous rate hike in June is affecting financial conditions and the economy. By contrast, I'd say that the amount of new information available between now and the September meeting is actually quite limited. Most importantly, CPI data only would be available through August.
So if the BOJ wants, you know, the sufficient evidence to justify the rate hike, it's October is probably a better timing for them, but at the same time, they want to deliberately avoid closing the door to a potential hike in September because, you know, obviously if inflation risks were to intensify because of renewed yen weakness or even another move higher in oil prices, they do want to retain the flexibility to move before October. Very clear. And you mentioned the yen.
So yesterday, the Ministry of Finance reportedly conducted large intervention, possibly taking the opportunity of some dollar weakness post FOMC to help accelerate that relative yen appreciation. But today, the yen weakened again post BOJ. So do you think this market reaction will have an impact on the BOJ stance near term or more medium term?
Yeah. So the yen, as I said, is an increasingly important variable for the BOJ as it thinks about the inflation outlook and the upside risks to inflation. Although I will say that the BOJ has made it very clear that its mandate is price stability and not the exchange rate.
So they're quite clear in saying they don't target FX, but they do care about FX because of its impact on inflation. And what has changed over the past year is that the BOJ has become increasingly explicit that developments in FX, so basically yen, now have a larger impact on Japan's inflation than they have in the past, which is why, you know, one of the reasons why in this latest outlook report, the FX developments were explicitly added to the list of risk factors that the bank is monitoring when it's assessing the timing and pacing of future hikes. Now, as I said, if an intervention, this intervention succeeds in stabilizing the yen, October does remain the most natural timing for the next move.
But if dollar yen resumes its upward trend, you know, particularly in response to U.S. developments, you know, perhaps we get very strong U.S. data over the next month that firms up a September FOMC hike. The BOJ may not have the luxury of waiting for the October data. So in that scenario, I think September move becomes more plausible as a risk management response to inflation risk stemming from a weaker yen.
Then there's also a very important political angle, which is that, you know, honestly, the biggest uncertainty surrounding the timing of BOJ hikes is perhaps not even the inflation outlook itself, but rather the government's tolerance for additional hikes. So FX matters because it is one of the few developments that can change the government's position. The latest intervention suggests that policymakers are increasingly uncomfortable with yen weakness.
And at minimum, dollar yen at 165 appears to be a level they are reluctant to see breached. So, yeah, October remains our base case. But if dollar yen, you know, yen weakens into the September meeting, September becomes more likely than a delay.
And what about beyond that? What is your baseline now for the path to over the coming year? Yeah, so it hasn't changed.
We continue to expect three additional hikes. I mentioned the next timing that we predict being October, but after an expected October hike, we see them moving again in March 27 and October 2027. That would take the policy rate to 1.75 percent by the end of 2027.
The reason we don't have additional hikes beyond that is not because we think, you know, inflation is going to slow down considerably. The reason we stop is because of the political calendar and also developments around the BOJ policy board personnel changes. So by, you know, 2028 spring, we will have the BOJ leadership reshuffle.
And then that summer, we also have upper house elections. So we think those events could complicate the BOJ's ability to deliver additional hikes from late 2027 onward. That said, I don't necessarily think 1.75 percent will become the terminal rate.
And if anything, the BOJ, the longer term risk, I think, is that the BOJ ultimately has to do more to contain inflation because, you know, of political constraints and these timing issues making hikes slower than would otherwise be justified by the inflation data. So again, in a nutshell, our base case remains, you know, normal, fairly gradual rate hikes to 1.75 percent by end 2027. But we do see a risk of a higher terminal.
Thank you. It's only very clear. Agnes, shifting to you, we also had the BOE meeting yesterday.
So how would you qualify their messaging this time? Hi, Svea. Thank you for having me.
The 6-3 vote split was more hawkish than our base case of 7-2, but I would not read too much into it as a signal of broader committee's thinking. Overall, I would characterize the BOE's message as fairly balanced. Policymakers kept the door open to a hike if second round effects prove more persistent, but they stopped well short of signaling that a hike is imminent.
That said, the outcome was dovish relative to market expectations. Combined with lower energy prices during the week, it did trigger a relatively sharp bull steepening in the sterling rates market, and the steepening gathered further momentum during the press conference. Governor Bailey commented that the committee is not getting closer to a hike, a message that Hugh Pill echoed today.
And Lombardelli, who is one of the more hawkish members of the committee, said that her decision to hold rates was not a close call. So together, these comments really reinforced the market's reaction in a shape of bull steepening yesterday. There was also a box on quantitative tightening.
Any interesting takeaways from that as well? On QT, the monetary policy report review did not prove to be a market-moving event, which was very much in line with expectations. But having said that, I was hoping for a little more.
So the updated bank staff analysis suggested that cumulative quantitative tightening has raised 10-year gilt yields by around 20 to 30 basis points, which is slightly higher than last year's 15 to 25 basis points estimate, although that mainly reflected the additional QT announcements in September 2025. We did have another $70 billion of QT done since then. The slight disappointment from my perspective was that the report offered no assessment of QT impact on 30-year yields relative to the 10-year sector, which is something that we had a small comment on last year.
Overall, I would not take too much guidance on October 2026 to September 2027 QT pace from this NPR. The range of plausible outcomes for the pace decision, I think, still runs very much from an unchanged $70 billion pace to a slowdown to $50 billion. The latter would leave active gilt sales unchanged at $20 billion, and to me, perhaps remains the most sensible option.
And more importantly for the rates market, a further skew away from long-dated sales, long-dated BOE sales also remains on the table, but we certainly didn't get any strong signals on that front from yesterday's NPR review of QT operation in the last year. Thank you, Agne, and Bruno, last but not least, we're shifting to the Fed. This was really the big event of the week.
It was bound to be an important meeting, given how undecided the market was about the possibility of a hike. How would you describe the outcome there? I don't think the market was that undecided when you look at the pricing, right?
So the market was pricing roughly 30-35% odds of a hike. Implicitly, that makes it 65-70% likelihood of a Fed hold. That is what the market was pricing going into the meeting, and that's exactly what the Fed did.
So no surprise, right? Wrong. So the backhand sold off sharply, the front end rallied as the market moved to price fewer hikes going forward.
It shaved roughly half of hike by December. Equity sold off sharply, the dollar weakened. So where was the problem?
I think the problem was in the fact that the Fed on hold in the context of supply-driven pressures on inflation requires very careful messaging, because there's a risk that the market sees the Fed as behind the curve. And the market saw a clear problem in the packaging of the message. The biggest moves came around the press conference and in the lack of guidance.
And those were the key issues. And this drove the market to price the meeting as a missed opportunity for the Fed to reinforce its inflation-fighting credentials, and ultimately, a potential problem of credibility for the Fed. And the key question in my mind is whether the market reaction reflects a problem of credibility on inflation or a problem of credibility more broadly.
And one is easier to fix than the other. But what this ultimately means is that the stakes are much higher for the Fed and for communication and for clear communication and guidance for the next couple of meetings. How do you see that going?
What's your view on the path ahead now? So there's a clear increase in stakes in terms of communication for the Fed. But on top of that, I think the Fed made the next couple of prints on inflation enormously important.
The July decision effectively tells us that the Fed is not yet convinced that inflation warrants an immediate or urgent hike. But it also tells us that inflation remains the dominant concern. So there were three dissents, and the Fed chair repeatedly made reference to price stability in the press conference.
So this issue is clear. The pro is by holding rates unchanged while simultaneously emphasizing inflation risk, the Fed risks creating a perception that is talking tougher than what is acting. And hence the title of our US section, the all hat and no cattle, right?
Acting tough and not acting. Credibility becomes increasingly valuable after several years of above target inflation, and the Fed needs to understand that it has the issue of credibility here. My baseline is that July hold should not be interpreted as reducing the willingness to hike.
If inflation remains sticky or energy-driven pressures continue to materialize, the Fed may ultimately need to do more than the markets actually turn to pricing. We moved from the pricing of December from 1.8 hikes to 1.3, so half a hike shape by December this year. That strikes me as an aggressive repricing, given that the committee inflation concerns have not diminished significantly.
There's two thirds of hike price for September. And the reaction function may have shifted in the sense that the hike is now the baseline with 65% price gain. And it's up for incoming data to fade the case for September.
So bottom line, next inflation prints are enormously important. The baseline is for a hike in September at this point. And communication needs to be a lot more clear from the Fed.
Thanks, Berno. And looking further out now at 10-year yields, what are your frameworks suggesting as fair value? Yeah, so this is really interesting, because we are sort of at the threshold here where you need to start to question models.
We need to start to question whether the regime in which the models were calibrated is still valid or not. So fundamental fair value for the 10-year is around 4.15, 4.2%. We're now 4.7.
So we're approaching two sigma cheap signals. And when we're looking historically at the sigma cheap signals, you have to question yourself, is this signal a real signal? Is the model self-consistent?
And are the results consistent? Or is something breaking that is not reflecting in the model? So that's sort of the biggest concern for me.
We have been fundamentally, when you look at macro data, in a bit of a reflationary phase. And we are, in my mind, peaking here in that reflationary phase. So it's likely that that reflationary cycle will fade over the next 6 to 12 months.
But I take all this with a pinch of salt, because when we see two sigma cheap or rich signals in models, normally you need to question whether something is breaking down. Thank you, Bruno. Thank you, Jumi.
Thank you, Agnes. Thank you for joining us today. We hope you found this useful and that you'll tune in next week. and other investment banking and markets activities are performed globally by affiliates of Bank of America Corporation, including in the United States, B of A Securities, Inc., a registered broker dealer and member of FINRA and SIPC, and in other jurisdictions by locally registered entities.
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