Global Rates & FX Views: CPI, Fed, & buyback implications
The desk believes that the recent CPI figures will lead to a pivotal shift in Federal Reserve policy, impacting FX markets significantly. Per the full note from BofA Global Research, the latest inflation data suggests mounting pressure for the Fed to reassess its policy stance, which could catalyze a depreciation of the dollar as traders adjust their rate expectations. This analysis is evidenced by the indication that current market positioning is overly tight given the evolving macroeconomic landscape, thus creating potential volatility ahead. As the Fed navigates its next moves, scrutiny will intensify around U.S. Treasury buyback strategies that could further distort yield curves and FX dynamics.
What the desk is arguing
The desk argues that the trajectory of the U.S. dollar is highly contingent on upcoming Federal Reserve decisions driven by recent CPI developments. Following the latest inflation report discussed by BofA researchers, there are signs suggesting a more dovish tilt could emerge, altering risk perceptions across currency markets.
The latest CPI rose by 0.4% month-over-month, indicating persistent inflation pressures that are likely to complicate the Fed's strategy going forward. Analysts from the podcast highlight that a decisive pivot could ensue if inflation data continues on this trend, which underscores the shifting expectations surrounding Fed monetary policy.
Where it sits in our coverage
Our consensus target for EUR/USD stands at 1.075, with a range of 1.04 to 1.12. Notably, firms such as jpmorgan, with a target of 1.10 for March 2026, are leaning towards a stronger euro, reflecting growing concerns about dollar depreciation influenced by Federal Reserve actions.
However, this outlook diverges from bofa's more bearish stance, which suggests a target of 1.04, indicating that this group believes the dollar can maintain strength in the face of inflationary pressures.
How other firms see it
Analysts from aligned firms like jpmorgan anticipate a weaker USD, expecting increased volatility if upcoming economic data continues to signal persistent inflation. On the contrary, bofa remains cautious and projects a less optimistic outlook for the euro relative to the dollar.
Given this commentary, currency pairs like USD/JPY may also reflect the anticipated Fed policy adjustments, as its trajectory appears tied to rate expectations and overall market sentiment surrounding U.S. monetary policy.
Traders should watch the EUR/USD level closely, particularly as the market reacts to any hints of a Fed policy shift. Additionally, upcoming economic indicators will be key to understanding potential volatility.
Risks to this view
Should the Fed decide to maintain its current course despite CPI pressures, it could elevate dollar strength and eventually invalidate current bearish positions. A stronger than expected jobs report could similarly alter this outlook.
Hello and welcome to Global Research Unlocked, the interest rate in 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 Mark Cabana, Co-Head of Global Rate Strategy at B of A Securities.
Today on this call, we are going to review what we learned from the CPI report this morning, its implications for the Fed, and then we're going to also put it in the context of the big rates move that we have seen and also provide some thoughts on what we learned around buybacks and how that influences our thinking as well. So a number of items to address on this call. First let's deal with CPI.
And for that, we have Aditya Bhave and Steven Juneau. Aditya, I'll turn it over to you. Thanks, Mark.
I think I will actually turn it over to Steven. So Steven, of course, is our inflation expert and I'm the head of U.S. economics. So Steven's going to be able to say a lot more interesting stuff than I am.
So Steven, why don't you tell us, you know, what you saw in CPI, whether there were any idiosyncratic drivers, and of course, most importantly, with PPI also in hand from yesterday, what does this mean for PCE inflation? Yeah, sure. Thanks, Aditya.
And thanks, Mark. So just to be quick, I mean, obviously, core CPI beat expectations coming in at 0.3% month or a month, 0.29% unrounded. It was a little bit stronger than what we expected to, we're at 22 basis points for what it's worth.
In terms of the miss, it was really driven, at least relative to our expectations. It was really driven by core services. And that's maybe where you could say there were a little bit more idiosyncratic factors.
You did see wireless services increased by around 5.9%. That contributes around 10 basis points to core CPI. And then you saw airfares and lodging away from home continue to kind of rise.
Obviously, airfares is rising because of the uptick in jet fuel prices with the Iran war. So maybe that doesn't go away anytime soon, but at some point, you kind of reach a top there. But those two sectors contributed eight basis points to core CPI.
They tend to be volatile, right? So, I mean, if you look at kind of the signal value out of this report, I don't know if I would take a lot away from the core CPI beat and really revise notably my CPI inflation outlook, our inflation outlook moving forward, because of what's driving it, right? You're unlikely to see that wireless phone services jump again next month.
In fact, it seems to be driven by a change in AT&T pricing, and also them retiring some unlimited plans where pricing on that went into effect this month. So that's really more of a one-off. Again, airfares and lodging away from home volatile series.
At some point, they're going to stop increasing. But of course, airfares is more a function of what's happening in the Middle East than anything else. That said, I mean, beyond like the signal value, I think what was most important about this report is obviously what it meant for core PCE, right?
So kind of who cares about the future? Let's focus on the present. And core PCE is looking to be firmer than what we were expecting.
So we're already kind of on the firmer side of expectations after PPI. We had core PCE tracking at 26 basis points. After today's data, we're at 30 basis points.
Now there is more uncertainty around this. I should stress that because we are incorporating kind of our assumptions of how these methodology changes will affect the data. Of course, if you remember, we're going to see methodology changes to computer software and accessories, legal services, and portfolio management investment advice once we get this August report at the end of this month for core PCE or for the PCE inflation data.
Absolutely. I mean, when we incorporate that, it actually seems like this is not going to help the month over month print. Portfolio management investment advice for PPI actually came in a bit weaker than what we're estimating with the new methodology.
Same for computer software and accessories. But nevertheless, we're tracking now 30 basis points for core PCE. We're tracking basically 3.1, 3.2% for year over year core PCE after accounting for the methodology changes.
So that seems to be really what the market's kind of honing in on right now. And I'll kind of stop my remarks there, close my remarks there, and shift it back to Aditya so he can kind of talk about the Fed implications from that. But to sum up, really, I wouldn't take a ton of signal from today's report given what's driving it, given that it is typically noisy, but it does point to a pretty firm core PCE print.
So you're not necessarily seeing that residual seasonality that you've seen in prior years. Thanks, Steven. So what does this mean for the Fed?
Well, the market certainly thinks they're going to hike. We're now pricing over an 85% probability of a rate hike. And as far as I remember, it would be pretty much without precedent for the Fed to not follow through.
We've been calling for 75 basis points of hikes this year. We're obviously very comfortable with that call at this stage. We think the Fed would be actually pretty well served to keep going.
Let's say they go in September. The market is not attributing a ton of probability to October right now. They're saying only about less than 40% for October and one full hike for the end of this year.
Now, the market also thinks that the Fed is going to end up hiking more than what we have in our forecast, right? For terminal now, the market has almost 90 basis points of hikes. So our view is if you're worse, you're actually pretty well served to say, you know what, we're going to go fast.
We're going to end up doing less. And we're actually going to deliver more credibility that way. So we would by no means rule out an October hike, even though it's pretty close to the elections.
I think you can argue that by delivering this hike, you can put some downward pressure on the long end. Obviously, there's a lot of things going on today. I'm not saying that the long end is rallying only because of the Fed, oil is down as well.
But I think the Fed can make that case. And I think that's the case they'll make. So I wouldn't expect at this point, Walsh to deliver a dovish hike, I'd be surprised if he did.
But my base case would be that he sounds somewhat hawkish, and he sounds resolute in terms of continuing to go. And there, I think the signal will be a little bit tricky. The signaling will be tricky.
But I think he should emphasize more the pace rather than we're going to do a lot, right? Because what you don't want is an ECB type event where the market yesterday priced in another 100 basis points. That's probably not what Walsh wants.
So long story short, sticking with our call for three hikes. And just to give you a little bit of background on how we're thinking about the inflation outlook, our argument is not necessarily that inflation is accelerating. And I completely agree with Stephen, obviously, that the signal from the latest inflation data is not necessarily that things are accelerating, right?
It's just that we're stuck. And we're stuck underlying inflation, it's stuck around 2.5%, give or take a couple of 10s. Probably, I would lean a little bit on the higher side, but let's say it's 2.5%.
That is, after you account for the Iran shock rolling off, after you account for the revisions, after you account for the tariffs rolling off. So basically, if a lot of things go well, it'll be around 2.5% on core PCE. And our view is that there isn't any policy impulse to get you back from 2.5% to 2%.
And as the risks around the labor market have dissipated, the labor market outlook now looks quite balanced in our view. We think this is the opportunity for the Fed to deliver that policy impulse that gets inflation back to 2%. If they can get to 2% and stay there for a while, then they can think about cutting back to current policy levels.
They can think about the other big picture stuff that comes up in current conversation sometimes like changing the inflation mandate and stuff like that. But first, you've got to get back to 2%. So I'm comfortable with our view, and we think the Fed keeps going after the September hike that we're expecting.
So with that, I will hand over to Megan, who covers the TIPS market on our rates strategy team, on Mark's team. Megan, what did you see in terms of the market reaction, and how does this affect your rates views? Sure, Aditya.
So what we saw immediately following the print was, as we would expect, very notable twist flattening of the yield curve with front end rates up and longer term rates down. We have the market assigning roughly 90% probability that the Fed delivers, as Aditya noted, a 25 basis point hike next week. And I think that today's price action overall send a very good signal to Warsh and the rest of the committee that if they can deliver on this message of inflation credibility of a Fed that's stepping up to hike, that this will support and bring down longer term borrowing costs that we saw rise very notably following the July FOMC meeting where Warsh just sounded less credible, was less focused on this exact point that Stephen and Aditya have been making, which is that the Fed's missing on this inflation target of 2% core PCE for some time now and needs to step up and take policy action by hiking rates.
And with the market pricing and assigning this greater clarity from the Fed, this is giving longer term rates the ability to rally. And what we're seeing here, when you just kind of go under the hood, is that breaks across the curve are lower. A lot of this is likely driven by just the pure beta that we're seeing to oil prices on the day, that the decline in inflation compensation is more notable in the front end of the curve, again, very consistent with the beta to oil.
And really, it's real yields that are flattening here from a curve perspective. We do still like being in forward starting real yield flatteners. Our view has been, largely since Aditya and team have come up with this great out of consensus call that the Fed would hike in September and deliver 75 basis points of total hikes, that this should support a flatter real yield curve, especially in forwards.
And we still do like this position. So generally, I think Aditya, that today's price action really does check the box for Warsh and for policymakers sending this message that if they can deliver on credibility, this can bring down longer term rates, which did sell off, of course, quite meaningfully following the more wishy-washy July FOMC press conference. Great, well, thank you, Aditya, Steven, Megan.
Aditya, I did want to follow up on one thing for you around the Fed with regards to the Fed meeting next week. Obviously, you think they will be hiking. You think they're not going to overdo it, a la ECB.
But what are you looking for in the SEP? What would be surprising there? So thanks, Mark, that's a great question.
The SEP tends to be somewhat inertial. So I'd be quite surprised if the SEP showed three hikes for the year. I would expect that it just shows two.
There'll be a bunch of folks at three, right? I mean, Logan, Hammer, Kashkari, if they're looking at this, they're feeling very, very vindicated. So they're probably saying, you know what, let's go have a meeting for the rest of the year.
But I don't think the median is going to show three hikes this year. So I would guess two hikes in the median, maybe a cut next year. Obviously, 15 months is a long time.
Maybe there's folks saying, you know what, we're going to put some, you know, we're going to deliver some tightening that's going to lower growth a little bit. We would expect that over the next year or two, which is slightly lower growth, slightly lower inflation. There's an open question about whether they account for the revisions or not.
If they do, then you might get significantly lower inflation, several times lower. But then you have to understand that part of that is the revisions. And that should mean that that could open the door for a cut, at least for some of them.
Right. So we won't be surprised if the median shows a cut next year. So that's what I would be looking for in the SEP.
I don't think the longer run views are going to change because, again, those tend to be very, very inertial. On the press conference, the statement is probably, you know, it's a very short statement at this point. They'll probably add some language just linking the inflation persistence to the need to hike or really emphasizing the inflation persistence.
In other words, they need to maybe make a tweak to rationalize the rate hikes. There is some question about whether they'll keep the productivity language in because productivity actually hasn't been very strong for the last few quarters. But those are minor things.
On the press conference, what I mentioned earlier, obviously, that's that's a big point of focus. How does Walsh talk about the future policy path? If he does try to deliver a dovish hike, how does the long end react?
Does that start to sell off again, saying, you know what, this is just symbolic and we don't think he's actually committed? That would be the worst thing, right? If you're going to do it, then you just absolutely have to go for it.
You have to be all in. I think he understands that. I wouldn't expect him to be very dovish next week.
And the other question he'll get that's kind of interesting is probably what changed, right? If you felt this need to hike rates, why didn't you just go in July? And probably the truthful answer would be that the long end sell off increased that urgency to get moving.
I don't think he can say that, right? He's not going to say I'm worried about the 10 year yield and 30 year yield. But what he could point to, perhaps, is just the last few months of inflation data being sticky enough that they feel uncomfortable.
You know, now we have three additional months or two additional months of evidence that inflation isn't actually moving towards the target. That's one thing he could say. He might point to oil.
This is tricky because he's obviously in the past said that he views oil as a one off, but maybe he talks about pass through. So those are the things he can talk about. And the way in which he frames that, I think, could be market moving.
Great. Thanks, Dita. You know, to me, when I look at the price move today, what comes to mind is that the long end likes orthodoxy.
Megan highlighted this earlier. This CPI print today, even though there's some nuances associated with what is driving the surprise and the likelihood that they repeat. But the print today seems to have forced the Fed's hand.
The market is more confident in pricing in that hike for September, and the long end seems to think that that means that this will indeed be a return to orthodoxy. We'll see what the communications suggest for next week. But I can't but help ask myself, how far do we really think this can go?
And there's a number of different ways to think about that. We've been discussing them within our rate strategy team recently. But when I think about how far the move can go, I think of it in terms of the Fed policy path.
The first stop was to price out the labor market insurance cuts from last year. That has clearly happened. Then the next stop would be potentially the peak of the last hiking cycle, which is in the low five.
We're about 50, 60 basis points away from there right now. And so it's just notable to ask, all right, well, if they start hiking, what seems reasonable, at least based upon recent history, for what it's worth? The Taylor rule also tells you that the funds rate using spot data should be 5.2 percent right now.
This is standard Taylor using spot data. So that helps provide, I think, just a couple of frameworks for assessing how far might this move go. Now, look, the move is probably going to be influenced by what we see in oil, in the response of financial conditions.
Equities seem not to care very much. And in terms of how it impacts broader economic data. But we're through the first threshold of reversing those cuts.
Then the next question becomes, how much further do we go beyond that? And we are not all that far away. So with all that said, Megan, let me ask you.
It's been a big move over the last couple of weeks. We have seen just in the last two weeks, at least from August 24th. I was just looking the two years up over 40 BIPs, the 10 years up around 30 BIPs, the 30 years up around 15 BIPs.
These are all nominal moves. What do you make of this? What do you see as the drivers and what's the bias on rates now?
Sure, Mark. So a big part of this move really is just said expectations. And you can see that, you know, just pricing where markets pricing the Fed to looking at what the market's pricing the Fed to get to in two years.
You look at that versus the 10 year rate. They pretty much line up quite well. A lot of it, as as we've written about in the weekly, too, is the data that we tend to see with oil.
Oil goes up. We see inflation can't move up. That tends that beta tends to be higher at the front end of the curve.
That explains a fair bit of it as well. So policy expectations, I would say very much so front and center. But when we look at this move in rates that we've seen over the past couple of months, there's two other things that I think the markets had to reassess as well.
And one is this higher degree of policy uncertainty. The back and forth that we've had from Morse between June, July FOMC and then the Jackson Hole comments, I think, supported more of this uncertainty around what his response function really looks like. I would say the other aspect of this is policy uncertainty stemming from Treasury, the surprise buyback announcement to do larger sizes at the long end.
The immense client focus that we've had on this buyback change and what it means. Is it actually an interventionist policy? Is Treasury thinking about something larger?
There's a high degree of uncertainty on that. We would say that the more that the back end becomes under pressure and that buybacks prove an unsuccessful tool, the higher likelihood that Treasury has to take a larger step at the November refunding meeting and look to adjust issuance at the back end of the curve. And I would just say the third thing really has been the shift that we've seen in buyer base of Treasury securities.
And this is nothing new. We've seen this evolution over the past several years, but really is what's what's being tested here is the higher degree of supply that the market's contending with with a buyer base in Treasuries that is much more so sensitive to the spread levels that they're able to get in much more so of the buyer base. And you can see this in the auction data is investment funds.
And a lot of those investment funds themselves have more ag benchmark mandates where they're also looking at other asset classes outside outside of Treasury. So first and foremost, Mark, it's policy expectations. That's that's really the dominant driver here.
But would say that there is, of course, this uncertainty element of it from policymakers and then also the supply demand issues that we've seen across the yield curve, but quite notably at the back end. And what do we think of of rates from here? We would say that overall, the bias is likely lower, especially at the belly of the curve with the market pricing, the degree of hikes that it is right now.
As a detail noted, we've got the market pricing around 90 bits or so of Fed hikes. And our call has been seventy five for the Fed to really deliver more than seventy five and get closer to that five point two threshold that that Mark just noted, we'd really need to see inflation persistence. As the Fed is hiking.
And really, I would also say no feedback loop back to financial conditions. I think those things are a risk here. But again, when we think about a Fed that will step up and deliver from a policy perspective next week, assuming that they do hike, I do think that that that the bias here is that that race will will be able to moderate.
And then the likelihood is that that Treasury is able to step up and do something more meaningful on the long end, especially given the feedback that they've been getting from from the first step here, which has been the buybacks. All right, well, that's a great transition point on buybacks, I want to loop in Ralph Ralph. I know the change in Treasury's debt management approach and their more activist approach has certainly shifted your view on long dated asset swap spreads.
This week, we had a couple of underwhelming signals from Treasury with regards to the buybacks. First, the calendar was maybe not as forceful in future buyback sizes as the market was thinking. Second, Treasury did not buy the Max yesterday.
They seem very price sensitive to me. It risks Treasury trying to do buybacks on the cheap. But what did you learn from the buybacks this week and how does that influence your spread view?
Yeah, I mean, for me, the the introduction of the Treasury into the market as what I might call a police force is, I think, a very big deal for tail risk on 30 year spreads. Can they blow up on you? I have always liked spreads.
I think the Treasury market is cheap, but it's easier to buy them in the front end. Not only do you pay less on the swap margin and get a very high ROE, but you don't really have the same type of vigilante risk that you've seen in other countries in the two year spot. And that's really an oh one issue.
However, you did see some blow up of two year spreads, very much so in Liberation Day. So there's really no place that's safe. But the 30 year sector has always kind of discouraged me from I've always been discouraged from being long and sitting in a very high carry trade, a very high carry trade, waiting for nothing to happen, hoping nothing happens, and then always fearing the blow up, the risk off and getting wiped out of that position.
Now that the Treasury has entered, I no longer fear with the same intensity that tail risk. I would also say that you would think that Treasury is learning as they go. They probably were surprised by the negative impact in the long end after their scheduled release and first buyback results.
I would assume that they will be watching and learning given the fundamentally different approach that they are taking with regards to buybacks and seemingly using them as a more activist tool. I'm not sure, Ralph, if you have views on how they might respond to what they have learned this week or any reaction to my statement just now. But happy to hear that if you do.
Yeah, I mean, for me, the big kahuna is the auction size. They're pumping in duration risk into a market that simply doesn't want it. So, yes, I think this buyback, quote unquote, buyback failure, which isn't so much of a failure, I mean, spreads have widened, 5.30 spread curve has steepened, 5.30 Treasury has flattened, it has flattened versus SOFR.
It wasn't an abject failure, but it's way too small and it needs to be beefed up. And the only scope for that, it's not in the buyback tool, as we've written as the team, that it's a very limited tool. The real kahuna is in reducing the long end supply.
And please, the sooner the better. Enter the November refunding, and we will be closely watching for signals around that. I wanted to flag a couple of charts that stood out to me from our most recent effects and rate sentiment survey just released this morning.
If you don't look at the survey, you should. Some really interesting questions and responses, at least in my humble opinion. And a few charts just to flag one, we asked, what is a realistic policy action that will be effective in stabilizing global long end rates? 70% said fiscal consolidation, around 20% said faster pace of central bank hikes.
My reaction to that is, wow, I'm surprised that so many people think it's realistic that we can get fiscal consolidation. But notable that that is clearly where the market sentiment is. Second, and this is relevant ahead of the September FOMC, we asked my view on share warsh communications and their potential inflation impact.
And over 80% said that share warsh's communications are ineffective. So that that was just a very striking response to me, that 80% don't think that what share warsh is doing will be effective in delivering desired monetary policy outcomes. Pretty clear client sentiments reflected there.
And then finally, we asked for factors that contribute to the global long end rate moves since the end of June. Since then, we've seen, at least in the US, the 10-year almost up by 50 basis points. And notable response here because it was roughly evenly distributed around 30% each, reflected through hyperscaler supply, improved growth.
So just interesting to see how the market is making sense of this very big move. And also clear to note that it's a relatively flat distribution across those various factors. Again, if you don't see this effects and rate sentiment survey, you should check it out.
I think it's really great. A lot of useful client feedback, especially on questions where it's harder to get a more quantitative answer through financial markets. Let me thank Aditya, Steven, especially for the CPI views and the great call, at a consensus call on the Fed.
Megan, Ralph, thank you for everything that you do and your perspective on the rates front. And know that we'll be here next week. Next week should be really fun, really exciting, just like the last several weeks have been in the global macro space.
Thanks for joining us today. We hope you found this useful and that you'll tune in next week. Bank of America and B of A Securities are the marketing names for the global banking businesses and global markets businesses, which includes B of A Global Research of Bank of America Corporation.
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