Policy Derby: Rates for the Roses

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, head of US rates strategy at B of A Securities.

Happy Friday, everyone. Thank you for dialing in. If you didn't understand the title of this weekly call, then I'd be happy to explain it to you over a mint julep sometime.

If you don't get the mint julep reference, then I would welcome you to visit the great Commonwealth of Kentucky at some other time. As a reminder, conflict disclosures for any securities mentioned on this call can be found on the conference call invitation. We had another week where rates in oil went up, though we did get a little bit of month-end reprieve yesterday.

Central banks were very much in focus this week, and what we're going to do on this call is that we're going to do a very quick around-the-horn for all of our key analysts covering major central banks. We're going to ask about what they learned from the central bank, how that impacts their views, and then the trades that they like. So here we go.

Starting with the Fed and Ralph Axel. Ralph, from the Fed this week, what did you learn? Thanks, Mark.

This is the first time we've had four dissents in an FOMC meeting since 1992. In 1992, the Fed was cutting rates, and they decided to pause, and people got upset. Sixteen months later, they delivered the bond massacre of 1994, raising rates.

I am very taken by the shift in the FOMC towards a more neutral stance. They're getting nervous. Ash Carrey's statement about inflation and the impact of oil was extremely hawkish.

I think the market was only pricing a flat Fed this year. There's a chance that we could price hikes into this year. The Bank of Canada was also extremely explicit that if oil were to stay high or rise, they would hike in sequence.

All right. So we're going to get to Bank of Canada with Katie later, but impact on your broader rate views? Sounds like it shifted.

We are now concerned that the two-year rate can rise as hikes may get priced in whether the Fed delivers. That is another story, but we think the markets can price in at least a hike in the next 12 months, if not more. This should mean a higher two-year rate.

It should also mean a flatter, say, two's-five's curve. Okay. Great.

Thanks, Raul. Let's now pivot to the ECB. Fia, what did you learn?

That's pretty simple. I learned that the ECB is all but set to hike rates in June. There are five elements that make this signal of a hike quite explicit.

First of all, Lagarde noted that directionally, we know where we are going, and we will have a lot more information in June. Secondly, the decision to honk was unanimous, but a hike was also discussed this week. Third, it was reiterated that the ECB's baseline and adverse scenarios embedded two hikes.

Fourth element, Lagarde stated that there was no need to move today because the market had done some of the work for them by pricing those hikes. And finally, she also noted that even if the war stopped tomorrow, there would be consequences on policy. How did this impact your broader rate views?

We continue to think alongside our economists that the ECB will deliver two hikes in June and July. What I think is interesting from a curve perspective is that even if it didn't deliver a move this week, this explicit language means that the ECB is not behind the curve or doesn't appear behind the curve. So that also means the front end can remain the main driver of the curve.

We're less likely to see bear steepening scenarios on higher oil and more likely to see bear flattening scenarios. Great. Thank you.

All right. Let's go to the Bank of England. Mark Capelton, you there?

Yeah. Hi. Awesome.

What did you learn? We didn't have the same clarity from the Bank of England as Svea has just described from the ECB, partly because the Bank of England changed its presentation methodology, moving from a kind of central case to a distribution of scenarios. But the market took it overall as dovish, and that seems fair.

The vote came in at 8-1 rather than the 7-2 that we had expected. And Bailey was keen to convey the idea that they have time to assess the prospects. He did ratify the market profile of rates that they had assumed, but that was a much more dovish profile of rates relative to where we were yesterday.

The market reacted favorably to that. How does this impact your broader view on rates? Well, the problem for the gilt market, of course, is that there's a whole bunch of other things that the market is worrying about at the moment.

We have local elections imminently and concerns about a change of leadership within the ruling Labour Party and therefore a change of prime minister and possibly a relaxation of fiscal discipline as a result of that. And we have some big upcoming decisions about whether Bank of England will slow the pace of QT. So there are a bunch of other issues that are of concern.

But I think the key message for us is we're more or less with the market on pricing for this year, but we do expect rate cuts next year, which the market certainly isn't pricing. So perhaps the Sonia curve needs to be flatter. Great.

Thank you. All right. Moving along.

Let's go to Canada now. Katie, Bank of Canada. What did you learn?

As expected, the Bank of Canada held rates. But what was more notable, as Ralph alluded to, was the hawkishness of this press conference. It showed a clear bias around their concerns for the potential upside to inflation rather than the weakness in the broader economy and the potential downsides from higher oil.

Governor McClellan even reiterated multiple times during his press conference that he would be willing to hike rates consecutively if inflation doesn't come back down fast enough. So while the Bank of Canada implied they could be on hold for a while, it was a much clearer signal that the Bank of Canada's next possible rate move has shifted from a potential cut earlier this year to now multiple potential hikes. How does this impact your broader view on Canadian rates?

The market very quickly priced in hikes after this meeting. And now they priced two hikes for 26, and three hikes are priced by the second half of next year. However, if you look at the backdrop in Canada prior to the Iran conflict, you had inflation right at their 2% target, you had weakness in the labor market, trade uncertainty weighing on growth, and roughly half a cut priced in for the year.

And fundamentals haven't changed much outside of inflation, but inflation expectations are still very well anchored. So we really don't see a need for the Bank of Canada to hike rates at this moment, and we continue our call for them to remain on hold through the rest of the year. So in this environment, we think CAD rates likely realize lower than what the market is pricing.

And you can also see the front end curve steepen if these hikes get pushed out. Great, thank you. Bonus just for the listeners, Katie had a great note out this morning on Canadian repo dynamics.

So do check that out if you care about global funding. Bank of Canada, it sounds like, has not added enough permanent liquidity to keep their money markets under control. OK, now let's go to the Bank of Japan.

And Yamada-san, thank you for staying up late to join us, Yamada-san. Similar set of questions for you on the BOJ. What did you learn?

Yes, Mark. So up until early April, the Bank of Japan signaled to the market they were ready to hike in April, but their communication suddenly changed around mid-April and they did not hike last week. And it was likely due to the government pressure.

We learned two things. First, BOJ independence is compromised. And second, this is my view, but the Takahichi administration lacks understanding of monetary policy and its market impact.

Great. So how does this impact your broad view on Japanese rates? Yeah, so it strengthens our view that the Bank of Japan is behind the curve and they will remain so under the current administration.

So slower hikes, higher break-evens and steeper curve. Yamada-san, we've seen some signs that look very much like there's been Japanese official sector intervention on the yen in the last trading day or so. What is your take of this?

How far does this go? What does it mean for the currency? And how do you think about it in the context of Japanese monetary policy?

It seems the government has decided to buy time by FX intervention, but what I'm worried about is if the government is aware of its limit, the government was more or less successful in buying time by FX intervention in 2022 and 2024. They defended the line in the sand and that they did not deplete the reserves much. But the situation is different today.

U.S. rates are rising. Oil prices remain elevated. Spec yen short position is not crowded.

I think the decision to rely just on FX intervention can turn out to be much more costly this time, and they may have to deplete reserves a lot more. So I don't think FX intervention will be able to end this yen depreciation pressure. The BOJ will have to coordinate with MOF by hiking rate soon, likely in June.

And if they hiked in April, it was more effective. But I think a June hike will help, but it will still be too late to be effective. Thank you.

We also have another event next week. Unfortunately, we don't have our regional rep to help us with this, Oliver Levingston, but that event is the Reserve Bank of Australia decision on Tuesday. Our economists expect a hike in a relatively close decision.

It'll ultimately depend upon how their board weighs upside inflation risks against downside growth risks. In terms of the impact the decision will likely have on rates, especially the characterization of the outlook. They generally think that if it's a more hawkish set of communications that indicate concerns about second round inflationary effects, you could potentially see the front end of the Aussie curve sell off 15 to 20 basis points.

However, if it's a relatively cautious wait and see approach, especially if they don't hike, you could potentially see the market rally similar 15 to 20 basis points, so pivotal as far as they're thinking around what the outlook for Aussie rates means, and certainly a big risk event next week to watch on the central banking front. That is all for our central bank roundup. I did want to highlight a note that the global rates team put out this week, as far as a global plumbing primer is concerned.

Ronald Mann, you were a key part of that. Why don't you tell us what this global plumbing primer covered? Hi, Mark.

Sure. So we worked as a team globally to look at the plumbing of the Fed, ECB, Bank of England, and Bank of Canada. What we found is that these central banks have broadly similar macroeconomic aims for their monetary policy setting, but their implementation approach differs.

And these differences could impact the type of regime the central bank chooses to adopt, their policy toolkit, their balance sheet composition, and also how they treat any losses that they may incur. Awesome. Thank you.

Now, why did you write it and what did you really learn? What were the big takeaways to you? Sure.

So the background is that we've seen the size of global central bank balance sheets peaking in 2022 after unconventional monetary policy was used in response to the COVID shock. And since that peak, central banks have scaled down their balance sheets by unwinding those unconventional policies. Recently, we have seen balance sheet management diverge again.

Some central banks, like the Fed, are looking to stabilize their balance while others are looking to reduce it further, like the ECB and the Bank of England, and the chosen regime will impact money market rates. Central banks that adopt a supply-driven regime where reserves are permanently provided by the central bank, in those markets, the money market rates will be a lot closer to the deposit rate, whereas central banks that adopt a demand-driven regime where more reserves are created through the central bank's lending operations, the respective money market rates there will likely be nearer the lending rate. We learned that the perception of stigma could be an incredibly important consideration for the central bank in terms of which approach they take.

Central banks with stigmatized lending facilities may rather have a larger amount of what we call permanent reserves, and in turn adopt a supply-driven regime. But these permanent reserves will have to be weighed against the risk of central bank losses, as well as potential fiscal implications. Another thing we learned is that the central bank regimes are not only characterized between supply or demand-driven, and this made it much harder than we had initially thought for us to put central banks into different buckets, at least on a consistent basis.

So it really highlighted the nuances that market participants could benefit from when they think about global liquidity. Great. Thanks.

Finally, what are the market implications of this work that you did? Sure. Well, we expect a relative increase in dollar reserves versus other currencies, as the Fed sticks with a supply-driven regime and others move towards a demand-driven regime.

So this means that U.S. money market rates are likely to be more stable than euros, sterling, and even the Canadian dollar. A relatively low and stable dollar funding environment could also have broader implications, in particular on asset swaps. So we believe that would limit the cheapening of U.S. asset swaps versus its global peers.

Great. Thank you. Finally, next week, I'm just going to flag it here.

We won't go into detail on it unless there's interest in Q&A, but we do have the U.S. Treasury refunding next week. It's obviously a supply-risk event.

We think that they'll keep coupon sizes unchanged. And if you're looking for more detail around the nuances, Little Minutia will be looking for us to forward guidance tweaks. You can see that in our refunding preview published earlier this week, and the highlights also copied over in our Global Rates Weekly.

All right. Those were the key things that we wanted to cover. Let me thank every one of you for dialing in.

I'd like to thank all of our participants for their rapid-fire responses. Thanks for joining us today. We hope you found this useful and that you'll tune in next week.

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