Global Rates & FX Views: The great central bank review
The recent commentary from BofA highlights a significant pivot in global monetary policy driven by the Fed's hawkish stance, which has profound implications for FX markets. According to the analysts, this tightening move aligns the Federal Reserve with other major central banks, setting a new tone for yield curves globally. Per the full note, the immediate effects of the Fed's actions are already becoming apparent in currency fluctuations and the broader market sentiment towards rates. Observing the current environment, traders should remain vigilant for alignment or divergence among other central banks, particularly the BoE and BoJ, as the tightening cycle progresses.
What the desk is arguing
The desk interprets the Fed's recent decision to hike rates as a watershed moment in the contemporary tightening cycle, bolstering the case for a synchronized increase among major global central banks. This perspective stems from BofA’s view that such actions will reverberate through yield curves, impacting currency strength and market dynamics.
In their analysis, BofA stated that the Fed's hawkish move signals a broader global tightening trend. This comes at a time when the yield curves for the U.S. have steepened, reflecting market expectations for continued monetary policy tightness. The pace and scale of such moves could further influence subsequent policy decisions from the BoE and BoJ, which are also facing respective inflationary pressures.
How other firms see it
While jpmorgan supports the view of synchronized tightening, exhibiting alignment with this hawkish outlook, bofa has a more cautious approach, indicating they anticipate lesser tightening ahead. BofA's current targets portray skepticism about long-term rate increases, suggesting a divergence in future expectations among firms.
The dynamics surrounding the GBP/USD and USD/JPY pairs are particularly illustrative, as they are likely to reflect the varying paces of rate adjustments from the BoE and BoJ relative to the Fed's movements. Markets should monitor these currency pairs closely as they could reflect the underlying shifts in monetary policy expectations amid a changing landscape.
01The Fed's hawkish hike enhances the global tightening narrative.
02Increased pressure on yield curves is already evident post-meeting.
03Expect volatility in major currency pairs as central bank actions unfold.
04Focus on the BoE and BoJ responses in light of potential rate increases.
Market implications
Traders should keep an eye on USD/JPY and GBP/USD as these pairs may demonstrate heightened volatility and alignment with the ongoing rate hike narrative. Significant levels to watch include the 1.10 benchmark for USD/JPY, where a breach could signal further strength in the dollar amidst tightening conditions.
Risks to this view
The primary risk to this outlook centers on a potential dovish shift from the BoE or a surprise easing from the BoJ that could destabilize current expectations for rate hikes. Any indication of persistent economic weakness or inflation underperformance in these economies may prompt a reassessment of the tightening trajectory.
Hello, and welcome to Global Research Unlocked, the interest rate and effects series. This podcast is based on our weekly client conference call where our strategists, along with guests from other parts of BOV Global Research, discuss the most topical and pressing questions faced by our market. I'm Ralf Preusser, head of Global G10 rates and effects strategy.
Today is Friday, 18th of September. I'm joined today by Darsh Simha, head of G10 effects strategy, Agnes Dengaraitis from UK rates strategy, Megan Sliver from US rates, and Yamashita-san from Japan rates. Thank you all for joining and making yourselves available.
Yamashita-san, let's start with you. How do you interpret the rates after reaction that we had to the Bank of Japan today? Okay, thank you everyone for joining the call.
As expected, the BOJ raised its policy rate by 25 base points to 1.25%, whereas the hype itself has been fully placed in the two defending boards from DABIS board members, Asada and Sato, both appointed under the Takaichi administration, heightened market speculation about potential political pressure on the BOJ from Prime Minister Takaichi. Thus, after the statement was released, the markets gave back expectations for an October rate hike, and the 2.30 JGB curve strengthened. That said, Governor Wada's press conference was not super DABIS.
In our view, a 50-bit hike at a single meeting or a back-to-back rate hike was never a particularly strong possibility. Wada said that such a scenario would likely require either a significant inflation shock or growing concerns that the BOJ was falling behind the curve, similar to circumstances that prompted aggressive tightening by the Fed and ECB in 2022 and 2023. Therefore, I boldly agree with the market reaction.
Markets have largely priced out an October hike, with the implied probability falling to around 18%, while expectations have shifted toward a December move. We remain comfortable with our baseline call for a further 25-bit rate hike at the December meeting. Back to you.
Thank you, Yamashita-san. We also had some announcements on liquidity. How should we think about that?
Yes, let me also briefly touch on the changes to the climate-related fund-supplying operations. In our view, these changes are unlikely to have a meaningful market impact in the near term, but they could become more important from a longer-term balance sheet perspective. At the September meeting, the BOJ revised its fund-supplying operations to support financing for climate change responses.
The changes include a new method for calculating the loan rate and the introduction of caps on the amount of lending available under the program. Specifically, the loan rate will no longer be the IOEL prevailing at the time the loan is extended. Instead, it will be based on the average IOEL over the period during which the loan remains outstanding.
That said, the immediate impact is likely to be limited. In the most recent operations conducted in July 2026, loans under this operation amounted to roughly 14 trillion yen, while outstanding loans stood at around 25 trillion yen. Thus, the new caps are not binding at present and are unlikely to lead to a near-term reduction in the size of the BOJ's balance sheet.
Further, we see these measures are laying the groundwork for a gradual reduction in liquidity provision as the BOJ continues its balance sheet normalization process. In that sense, the changes can be viewed as another incremental step toward normalization. Looking further ahead, we continue to expect the BOJ's balance sheet to shrink as one of the fastest paces among major central banks.
Ongoing QT together with the gradual runoff of the funds provisioning measure to stimulate bank lending. It is likely Shibataro should continue to drive the normalization process over the coming years. Back to you.
Thank you, Yamashita-san. Now, you have maintained a constructive stance on the long end of the JDB curve for the last few weeks. How much of that is about your faith in the BOJ and how much is about your views on issuance?
Sure. Our constructive view on the long end is driven primarily by improving supply-demand dynamics rather than BOJ credibility. While we recognize that concerns about the BOJ falling behind the curve have risen amid growing political pressure from the Takaichi administration, we continue to see several supportive factors for the long end of the JDB curve.
First, news flow around large investors, particularly major pension funds, has been supportive of sentiment toward the end duration. Second, our estimates suggest that net JDB supply relative to nominal GDP will decline in 2027 compared with 2026, largely reflecting lower redemptions of JDBs held by the BOJ. Third, we continue to see flows of deep buying demand in the long end, particularly from non-Japanese investors.
Taken together, we believe these supportive supply-demand factors outweigh the risks associated with the behind-the-curve narrative. Thus, we continue to maintain a constructive and bullish bias toward long end JDBs. Back to you.
Thank you very much, Yamashita-san. And Adarsh, let's stick with the BOJ. How should we think about the FX market reaction post-meeting?
Thanks, Ralf. So the FX reaction, I would argue, was much bigger than the rates move implied. So if I think about it, the BOJ hiked, Ueda's press conference was pretty balanced, Yamashita discussed the changes in the rates market, but ultimately BOJ pricing, six months to one year out, did not change that much, and the long end was fairly well-behaved.
So what that tells me is the outsized yen sell-off that we saw was ultimately all about FX policy credibility. And it's important because we have been constructive on the yen for a variety of reasons, but one of the reasons has been our assumption that the various stakeholders on the exchange rate, the Bank of Japan, the Ministry of Finance, Takeichi, as well as the U.S. Treasury, are aligned in terms of delivering what is needed from a policy perspective to stabilize the yen.
So the defense by Takeichi appointees was important because it does challenge that assumption to some extent, and I think that's the way the FX market saw it. And that's why the yen sold off so much more than the rates market move would have implied. But I'd also argue that it doesn't invalidate the assumption just yet, because ultimately the BOJ hiked.
We do expect more policy steps to follow, not just on monetary policy, but other measures as well. And as I said, there are other reasons why we are constructive on the yen. But make no mistake about it, I think near-term FX credibility has taken a bit of a hit.
And I think from an investor standpoint, there will certainly be less appetite in the near-term to bleed carry, to be long the yen in the interim. Now the fun bit about your asset class is that it's never about one side, because it's two sides to the equation. So how much do you think the Fed matter than the yen reaction that we had, given that it's obviously also a FOMC week?
Yeah, Ralph, I mean, traditionally people always like to say the Fed matters a lot more than the local central bank, and especially in the case of dollar yen, it's said quite often. However, if you look at the price action, we've had a bigger move in dollar yen after the BOJ meeting than we did after the Fed meeting. So I think the BOJ is important for the reasons that I mentioned.
But of course, the Fed is important. And I think the fact that the Fed raised the hawkish bar, if you will, on Wednesday, obviously made it a bit more challenging for the Bank of Japan and for front-end pricing to kind of match those expectations. So I think the Fed is important.
The dollar has strengthened broadly, of course, and I'm sure Megan will talk about this. We expect front-end rates to move higher in the US. The question I've been getting is, is the Fed hawkishness sufficient for the dollar to reach new highs?
And I think that will prove a bit more challenging only because, yes, the Fed is hawkish, but so are the central banks. And when I look at US growth divergences versus the rest of the world, things stand out less than they did, say, over the summer when the dollar did strengthen, but it never really broke out of its range. So the Fed is important, but I don't see enough here yet to suggest that we're going to break to new highs in the dollar versus, say, the euro or the DXY basket.
Thanks so much, Adarsh. So Megan, let's stick with the Fed. What was your main takeaway for the rates market?
Main takeaway, Ralph, is that Warsh thinks that policy rates are not restrictive, and he really rejected any academic definition of where neutral is. All we know is that he's on this path to find restrictives and is going to be likely relying on the market to tell him where that restrictive policy rate is. What really stood out to me is that he framed the hike as removing accommodation rather than tightening policy.
And in general, a Fed that's using the market to tell it where a restrictive is, is really going to be looking at financial conditions. We look at what really drives financial conditions at the end of the day, it's the equity market. And with equities pretty much unfazed by the market pricing, about an additional 80 basis points of hikes from here, we think that there's just more work that the Fed has to do.
Thank you very much. So what are your duration and curve views after the Fed? We think there's more room for front-end rates to move higher, and we think that there's more room for the curve to flatten.
We can go through a few different frameworks to try to assess what policy rate the Fed is going to have to get to here. We talked about this in our weekly, we also had a nice note out this morning going through this. What we look at is Taylor Rule using the updated R-star from the September FEP and FEP projections.
You can use where real policy rates sit right now versus the unemployment rate. Also just looking at, you know, the FEP gives us some nice information on this in terms of how the committee, or I should say FOMC participants at large, are thinking about distribution of risks around unemployment and inflation. All of the focus right now is on inflation.
And you can use these frameworks to look back in time and sense where the Fed should be setting policy rates. And all three of these frameworks tell you that they're headed to a policy rate that's above 5%. Importantly, though, this pass-through to longer-term rates we think is going to be more limited.
I just did some work on this in the weekly, too. If you look at the beta that we see between where the market's assessing Fed funds go over the next 12 months and the 10-year, that beta tends to historically be pretty low and historically low when the Fed is hiking. Much lower than when the Fed is cutting rates or when the Fed is on hold.
So we do think that this supports more of a flattening view on the yield curve. I think that's especially true if the Fed is looking to financial conditions to tighten to tell it where restrictive is. Right now we also see in a lot of our positioning work that the market's short duration right now, quite heavily underweight duration versus spread product.
So positioning also supports that if we do get more pressure on risk assets from a Fed that's committing on this pass, that there's going to be less pass-through to the long end of the curve. So we like the flattener here as well. Great.
Thank you. Agnes, Bank of England, same starter question for you. What matters for the rate market?
Hi, Ralph. So what mattered for the front end was the balance in Bank of England's own at the meeting given their fairly explicit guidance in July that the bank were not edging towards a hike. So a repeat of that rhetoric as in July would have come across as tone deaf now.
It was reassuring to hear the BOE sounding more decisively hawkish compared to their tone in July yesterday, and the MPC certainly signaled that they are looking closer to moving towards a hike if recent rise in energy prices sustained and also barring big downside data surprises. But equally as importantly, the MPC also implicitly pushed back slightly against the market pricing of around four hikes, saying that some of it reflected a risk premium. And Bailey also highlighted that they didn't discuss the prospect of raising rates four times.
So overall, the BOE sounded reassuringly hawkish, and this hawkish hold resulted in slightly lower yields in the MPC-dated SONIA contract, indicating that this communication challenge was successful for the bank. And then the second point of interest for the market was the QT vote. The bank's overhaul of the QT sale process was not fully expected, hence turned out to be the big market mover on the day, with long-end yields rallying over 10 basis points and also outperforming SONIA by a few basis points.
And so the announcement of the cessation of QT market operations, although not QT altogether, was essentially taken well by the market given the rally and bullishly for the long-end as well. Great. Many thanks.
So how should we think about that QT announcement that you already touched on? Yeah. So we're still waiting on some operational details on how this new New Zealand-style QT will work.
But overall, we got a slower pace, which was expected, but with potentially some more support for yields than would have been the case under status quo. So in particular, what should support yields would be the likely absence of active yield sales for the next six months, while the bank and the Treasury iron out the technicalities of this new style of QT. And also the perception that this new approach with the DMO and control of the supply-weighted average maturity would be more effective in limiting the impact of QT on yield-term premia.
Essentially, it's better to have one arm of the state selling yields than two. And responsibility for the structure of that profile should rest with the Debt Management Office. But an important thing to stress is that the net value of yields to be absorbed by the market from active sales will be the same.
We will get an extra 20 billion yield sales from the DMO rather than 20 billion from the bank. So the strong bull flattening on the news yesterday really represented, we think, this market expectation of a six-month pause before active sales resume. And also the view that additional sales from the DMO will be perhaps a bit shorter maturity than they would have been the case if the bank continued with the way they did the QT so far.
Great. Thank you. Adarsh, let me come back to you, and I guess same question as for Japan.
How do you think about the Sterling reaction? Was this about the Bank of England or was this about the Fed? So again, if you look at it optically, Ralf, if you look at cable, it's actually the opposite of what I said for Japan.
So the sell-off in cable after the FOMC was larger than the sell-off that we saw after the Bank of England. So optically, you could say the Fed was perhaps more important than the Bank of England. But I think the reaction to the Bank of England decision was interesting.
It seemed to me that the FX market was very much focused on the drop in front-end rates. And that's why Sterling weakened not just against the dollar, but against a trade-weighted basket. But in some sense, the FX market didn't respond to the gilt market reaction.
As Agnew was saying, the UK gilt market took the direct DMO QT sales quite well. And usually when the curve flattens, particularly for a country like UK, where we're always fixated on fiscal risk, Sterling tends to benefit. And that didn't happen yesterday.
So in our view, I mean, lower gilt term premium over time does matter. And therefore, we don't know the counterfactual. Maybe Sterling would have been a lot weaker in the absence of this QT announcement.
But we do think, ultimately, this is a good thing over the medium term for the pound. And we do think Sterling should outperform, particularly versus a currency like the euro, that faces similar challenges in terms of potentially hiking rates in response to supply shock. Great.
Thank you, Adarsh. Thanks for joining us today. We hope you found this useful and that you'll tune in next week.
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