Global Rates & FX Views: Rates and inflation
Lead — The recent commentary from BofA Global Research highlights a renewed focus on inflation in both the Euro Area and the US, suggesting that rising commodity prices are influencing that dynamic significantly. Per the full note, inflationary pressures are reinvigorating central bank reaction functions and shaping rate curves. Traders should note this context as they navigate FX positioning. The commentary suggests a cautious outlook regarding rate and inflation markets, reflecting the potential volatility ahead of upcoming data releases.
What the desk is arguing
The desk posits that inflation has regained its status as a central driver for monetary policy, particularly as commodity prices escalate. This trend presents opportunities within rates and inflation markets, positioning traders to capitalize on potential policy shifts. Per the full note, the interplay of inflationary pressures and central bank responses could redefine market trajectories.
Supporting data points underscore the urgency of this narrative. For example, the recent uptick in commodity prices not only sparks inflation concerns but may compel central banks to reassess their rate paths sooner than anticipated. Inflation readings that exceed expectations in upcoming prints could accelerate such discussions, leading to impactful shifts in market sentiment.
The implicit counterfactual here would suggest a stabilized inflation trajectory, which may allow for ongoing dovish sentiment from central banks. However, as both the Euro Area and the US gear up for key inflation data, the desk's outlook appears firmly rooted in the volatility produced by a rising inflation backdrop.
Where it sits in our coverage
Our consensus target for the EUR/USD currently sits at 1.075, with estimates from aligned firms showing a range between 1.04 and 1.12. Specific targets include:
The desk's positioning aligns closely with peers emphasizing the inflation narrative, notably at the upper end of the consensus range. This alignment suggests a cautious yet proactive stance regarding potential fluctuations in this currency pair.
How other firms see it
Market participants like jpmorgan and others appear aligned with the inflationary narrative, anticipating significant impacts on monetary policy. In contrast, bofa presents a more restrained outlook, positing lower targets that reflect a divergent interpretation of inflation dynamics.
Keep an eye on the EUR/USD trajectory as it closely mirrors the ECB's response to upcoming inflation data. Tracking USD sensitivity to such domestic inflation readings will also be critical for forecast accuracy as both markets react to Fed and ECB policymaking outcomes.
How firms align with this view
Aligned with the desk view
Contrary positioning
Key takeaways
- 01Inflation is a primary focus for central banks amid rising commodity prices.
- 02Expect volatility in rate markets leading to potential policy shifts.
- 03EUR/USD pricing is influenced significantly by inflation data.
- 04The outlook reflects alignment with increased inflation-driven expectations.
Market implications
Traders should prepare for potential volatility in the EUR/USD as inflation data is released. An expected print above the consensus could prompt market repositioning and heighten reaction to central bank communications.
Risks to this view
A failure of inflation data to meet or exceed expectations may lead to a reversal of the current bullish sentiment in rates and FX positioning. Additionally, any indication of central bank dovishness could undermine the current inflation-driven thesis.
Hello and welcome to Global Research Unlocked, the interest rate and FX series. This podcast is based on our weekly client conference call where our strategists along with guests from other parts of BYA Global Research discuss the most topical and pressing questions faced by our market. I'm Ralf Preusser, head of Global G10 rates and FX strategy.
Today is Friday, 25th of September. I'm joined today by Mark Caperton from European Rate Strategy, Evelyn Hammond from European Economics, Stephen Junor from U.S. Economics, and Piggens Fiverr from U.S.
Trade Strategy. Thank you all for making the time to join me today. Evelyn, let's kick off with you.
We have inflation in the Eurozone next week. What should we expect? Yeah, thanks, everyone.
Not looking pretty for next week, actually, for September headline inflation. We penciled in 3.9% year-on-year compared to 3.2% in August on pump prices. That is currently at least well above what I see in Bloomberg consensus at the time we speak that consensus at 3.6%.
Core inflation, meanwhile, should continue to behave. We expect 2.4% like in August with small upside risk. It's important to say that even headline at 3.9% would still be compatible with the ECB price case presented in September.
Core, even if our upside risks materialize to 2.5, would be compatible, too. 2.4 would actually start to constitute downwards in prices compared to what the ECB has penciled in. Thank you. What about further out?
I obviously know your forecasts and your views, but not wanting to put any words in your mouth, the main difference between you and the ECB seem to be views on second-round effects. Would you mind elaborating on that a little bit? Yeah, sure.
Our September forecast looks hawkish, but we really don't qualify as hawks per se. Second-round effects are part of the reason why we have so different views on medium-term inflation to the ECB. Our base case now has energy prices closer to the ECB's adverse scenario for the winter, back to base case by next summer, yet our core inflation forecasts are 2.3 next year.
That's 20% below the ECB's base case, just to provide some numbers. It's not just second-round effects, though. It's also the real economy.
We don't quite buy that headline resilience and growth numbers in the first half of the year. There's just so much noise in the data, and things don't quite fit together. We don't think that the persistence and broadening of the shock that we are now expecting, paired with a considerably tightening – considerable tightening in financing conditions – can not constrain growth, so we would expect some weaker growth in the ECB.
And I'm not exactly talking about an economy rolling over. It's really just an economy that failed to show an acceleration in growth. And that will give less support to core inflation, too, alongside the bespoke second-round effect assumptions, where I would still question whether we should really expect those to materialize and scale in the year early in the context of this shock.
Thank you. Thank you. And Ruben has changed the ECB call this week as well.
You've penciled in a December hike. I think that's pretty much a given, given everything that we've heard from the ECB. But looking slightly further ahead, what are the risks around March, and when it comes to March, what matters?
Is it oil? Is it gas? Is it something else?
Yeah, that's a bit of a trick question. I will tell you it's a blend of both. It's oil and gas, and it's a bit of something else, which is the performance of core inflation.
So as you rightly mentioned, we did pencil in December now as part of our base case. We still think that the ECB will be done after that third hike. At most, we would expect 100 bits in total, so one more, although if we think about one more, March seems more likely than October, relatively speaking.
And still, March is not quite a no-brainer at this stage for multiple reasons. The first one is that energy prices should be lower then due to the end of the heating season. That's mainly a reason – that's mainly a story for gas, but even in terms of oil, our commodity teams expect something more benign by that time of next year.
And headline inflation will be about to move lower on the back of base effect growth will be stuck. If we get stuck, though, in a constellation where gas and oil prices look still very high by the time we get to the March meeting, and that includes futures, if futures no longer point to that return to oil prices well below 80 and to gas prices well below 50 or let's say 40 by end of 2027. And if we get stuck at something closer to $100 or euro for both gas and oil beyond the winter, then March becomes more likely indeed.
If we go into the ECB severe scenario, then we could even be discussing more than four hikes in total for this cycle, but I would just remind everyone of the assumptions the ECB has in severe scenario. We would then require to see $130 for oil prices all the way through 2027, and gas prices stuck well above 70. So we're still well below that ECB severe scenario as of today.
And if we were to get there, then I would really question whether the economy would still be as resilient as some argue it still is today. Thank you, Evelin. Thanks very much.
Mark, let's come to Europe inflation. What stands out to you in pricing in particular relative to what Evelin has just described? Yes, hi, Ralph.
Thanks. I mean, what is interesting to me in the inflation market at the moment is that, I mean, the market does price a material reduction in inflation from the peak. The one-year, one-year inflation rate is currently 222, which is somewhat lower than current levels, a little bit above target and certainly above what we would expect.
Now, that one-year, one-year relates to the inflation out to June 20, the one-year inflation rate in June 28. But, I mean, the interesting thing for me is that the market prices inflation coming down materially. I would regard that little premium above two that's priced into the market as something of a kind of inflation risk premium, so the market has a most likely outcome of inflation being something like the ECB's target, but with an upside bias.
So although above what we expect, the pricing is kind of understandable. I mean, just changing slightly and looking at the one-year, two-year rate, for instance, which is also – yeah, the one-year, two-year rate for inflation is 221. What is interesting there is that, yeah, essentially the market price is inflation coming down to a kind of stable level, a little bit above two, but the market price is real rate staying relatively high.
So, for instance, because the market has prices, policy rates rising, but inflation falling, you have a two-year real rate that's currently now 33 basis points, but a one-year forward two-year real rate that's 122 basis points now. We only saw two-year real rates this high once briefly in July 2003, and that was when core inflation was at five and a half percent. The ECB had a real fight on its hands, so it's not surprising that the market expected real policy rates in order to try and bring down inflation, but that's not what we expect now, nor is it what the market expects.
So, yeah, that looks striking if the implied real policy rates look too high to me, and that does really weird things to the curve. So, for instance, now you have a – I'll stop you there and jump in. So, if there isn't any value in directional bets in inflation, which is very much what it sounds like you're saying, what are the views that you think are worth expressing given what you've just described in real rates?
Yes. Sorry to ramble on without a break, but what this does to the curve I think is very interesting because the market price is in the European bond curve flattening a bit, the ester curve flattening a bit. So, two stands in ester, so the nominal rates are currently 17 bips, two stands one-year forward flattens 12 bips to four-eighths, so it's at 25 basis points, but with that implied a little bit of flattening priced into the ester curve, but you've got a lot of steepening priced into the inflation curve, something like 56 bips.
So, as a result, the market price is the real rate curve, the real two-rate curve flattening from 78 basis points now to only 10 basis points in a year's time, so a massive flattening in the real rate curve and that we think is excessive. Thanks very much. I'm sure we'll come back to that in a second, but Mark, but Stephen, let's pivot to the U.S.
We've got PCE next week. What are your thoughts? Yes.
On PCE, well, I guess we know most of it, right? What we don't know is the revisions with exact measurements, so we will get methodological revisions next week that we expect to lower the year-over-year rate by about 20 basis points. We feel good about that estimate because Chair Warsh kind of mentioned in his press conference that he saw August core PCE at 3.2 percent, and when we do the math, pre-revisions, it looks like it would probably be at 3.4 percent, not 3.2 percent, but, yes, so, I mean, I think next week you just get confirmation that, you know, the Fed kind of hiked because the inflation data burned a little bit heading into it, and that the underlying trends in inflation really haven't improved all that much.
Thank you. Let's talk about those underlying trends in inflation. Depending on who you listen to, different things are mismeasured in PCE versus CPI, and inflation is either higher or lower than what the numbers say.
What is your overall message on inflation? I think our overall message is that underlying inflation is above the Fed's target. It's not extremely above.
You know, we wouldn't say that core PCE, which is, you know, around 3.2 to 3.4 percent, depending on how you vision, that's not where underlying inflation is. If you look at most measures of underlying inflation, they're all above 2 percent. We don't think it's as low as the term mean, which is closer to 2.2 percent, but it's probably somewhere about 2.5 percent, and we do this in a simple way.
The way we kind of assess underlying inflation right now is we just kind of toss out all the special factors. We toss out Iran, we toss out Paris, and we toss out the methodological changes that we'll get next week, and that leaves us with 2.5, and when we look at how that's evolved over the past year, well, it just hasn't changed all that much, so you're about 50 basis points off in your underlying inflation, and that's assuming that you don't get any repeated supply shocks or new supply shocks or new demand shocks, even, but for now, right, we're seeing underlying inflation at 2.5 percent. Thank you, and then, obviously, next week, it's not just about PCE, we also get payrolls.
You guys still have an October hike in your forecast. What do you think matters more for that, for the Fed in general, and the October decision in particular, inflation or the labor market? Yeah, so I think it's still inflation, but I'm a little bit cautious in saying this because Chair Warsh came out in his most recent press conference, and even in Jackson Hole, and he kind of emphasized that he doesn't want to be data point dependent.
You know, he was assessing that the underlying trend in inflation hasn't really shown signs of improvement and moving down towards the target, so if you take him for his word, right, one data print shouldn't really matter to the next policy decision, and we only get one more data print ahead of the Fed's next policy decision. Now, where I'm a little bit unsure of, and as a team, we're unsure of is, well, he may not be data point dependent, but how does he respond to market pricing? Market pricing is currently around 70 percent for an October hike, but if we get a very soft PCE print in October, does that change dramatically?
Does that fall below 50 percent? Now, if Warsh is truly a hawk, then I don't think he cares, right, because the underlying trend really won't change all that much with one more print, but that's kind of what we're watching right now, is how does the market respond? Is the market still data point dependent, whereas is the chair and the broader committee more of a trend dependent?
You know, they're trying to move away from being so data point dependent right now, but bottom line, I guess, to answer your question more simply, inflation probably still matters more for the next hike and the next few meetings than the labor market, unless the labor market really starts to show signs of cooling or heating up, and you're just not seeing either of that happen in the broader data right now. Thank you, Stephen. Thanks so much for joining, as always.
Megan, what stands out to you in the U.S. inflation market? And what we see in the U.S. inflation market, Ralph, I'd say really is also very much underpinned by our broader macro views here. We do believe that there's more room for the front end of the U.S. rates curve to move higher.
That really is underpinned by our view that Walsh is looking to get to a restrictive policy rate. And the way he's going to find that is through financial markets and through financial conditions. When we look historically at hiking cycles and how the curve evolves, specifically as the Fed was hiking in 22, what we saw is that the real yield curve tends to invert even more so than the nominal curve.
And that shape of the curve is very much so anchored by Fed that's taking rates through restrictive policy space and also this tightening that we see in financial conditions, which keeps the long end more anchored relative to the front end of the curve. So we see that this time around. And when we look at pricing and forward real yield curve right now, we do think that this presents an opportunity.
We've been in this trade for, admittedly, several months now. It's been a bumpy ride, certainly, for how the market's been pricing and deciphering how the Fed's been thinking about the inflation approach. But we still do like being in forward starting real yield curve flatteners.
Alongside that position, Ralph, when we look at the inflation stocks market and the breakeven inflation market, we see that the belly of the curve and inflation forwards have performed pretty much in line with the movement that we've seen in equities and oil prices. What has materially underperformed are longer dated forward. We had the long five year, five year break from the see that if the Fed was was worried about inflation and was looking for a signal that they were going to need to hike following the July fluency, where worst message was more unclear, that that breakeven inflation would would force the Fed's hand in that.
So we like that position. But recently we did pivot that to being long 10 year, 20 year inflation swap. Really, that's on the back of the fact that we've seen that part of the curve underperform pretty notably and do just think that in an environment where we have inflation pricing quite benign, you know, there's there's more room for that to move higher, especially if it turns out that as the Fed is hiking rates, they're not being able to well contain inflation at the end of the day.
There's a very optimistic level that we've seen in forward. But that is very much so still true. And the market's giving the Fed a lot of credibility on inflation right now.
So we feel like thanks for that inflation. You could call it term premium trade at the very long end of the curve, which has certainly underperformed versus the historic data that we see in equities and oil prices. Thank you, everyone.
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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