Summit, yen-tervention, & US rates

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.

We are holding this call on Friday, New York morning, May 15th. We have a new Fed share today. And we're going to be talking about global FX and rate market development.

With me, I've got some of B of A's best, Darsh Singh, who heads FX strategy, Megan Schweiber, who is a senior US rates strategist. And we're going to be unpacking what is yet another very eventful week, especially for global bond markets. Now, to me, I learned a new market acronym this week.

It's NACCHO. That stands for Not a Chance Hormuz Opens. And it's a little tongue in cheek, but I do think it's very relevant when considering global markets, because what if this is the new norm?

And what if this lasts for much longer than we all thought? Certainly, broad financial markets don't seem to care about that concept. Equities, tech, AI-related companies are essentially going vertical and pretty much continue to pierce new all-time highs almost every single day.

Global rates are seeing bear steepening everywhere with extremely notable movements today and this week in Japan, as well as the UK, especially at their long ends. We're seeing the dollar turn a little bit, and this is all in the context of arguably the most important global diplomatic meeting that we have had in quite some time between President Xi of China and Trump in the US. So we're going to unpack all of this.

Just housekeeping note, all disclosures for securities mentioned can be found in the conference call invitation. Now, with that, let's first go to Megan. What is happening in global rates?

It looks like, at least as we speak, we've hit an air pocket with Japanese rates higher by 15 basis points or so at the long end overnight, UK rates almost higher by 20 basis points as we speak. What's going on? Correct, Mark.

Really tough first day as Fed chair for Warsh. Tough first week given a suite of inflation prints that's all beat to the upside. And as we know, inflation is really bond market kryptonite.

Bond markets, right, fixed income investments, but importantly, and importantly for the treasury market, they're used as a diversification tool. And when the Fed has to consider hikes, when we have to think about what the Fed distribution looks like, and we see continued fiscal concerns, we see that globally in Japan and UK overnight, coupled with these inflation worries that we're now seeing globally as well, it is all contributing to this pullback in investor demand as folks look at other alternative asset classes for some of those diversification properties. And I do agree, Mark, that is a big concern here, given this risk that we have around what Fed and global central bank policy is going to do.

A lot of this upside inflation risk that we're seeing in some of the data this week, and then you couple that with growing fiscal risks globally, this all results in exactly what we're seeing here. What stops it, Megan? What puts the bond market back under control?

I think the simple answer is some combination of central banks hiking, delivering on these hikes, and risk assets responding in tandem with that. We are seeing some of that this morning as equities are taking a breather here and selling off. You need to see more of this risk off flow come back to fixed income.

And for that to happen, I think it has to be the combination of central banks stepping in meaningfully to combat this inflationary pressure and risk assets feeling that pressure as well that can ultimately then drive some of that rotation back into fixed income at what would be viewed as relatively attractive nominal rate levels compared to equity risk premium. A little fiscal discipline probably wouldn't hurt either. Okay, hold that thought, Megan, we're going to come back to you in a little bit more detail on U.S. rates specifically in just a minute.

But maybe let's pivot here to Adarsh. Now, Adarsh, I want to get your thoughts on where the FX market sits right now. But help me set the stage a little bit.

We had a big diplomatic event this week, U.S.-China Summit. What did you learn? And what do you think it means for markets, especially FX?

Sure. Thank you, Mark. The short answer to your question is we didn't learn very much.

The way I put it is that expectations were very low heading into the meeting. And they were definitely not exceeded. The U.S.-China detente holds, but there was effectively no major de-risking of the relationship.

So if you think about some of the different aspects on trade, the truce held, there was no hike in tariffs, there were limited deal-specific agreements to buy more goods. There was the so-called Board of Trade, but there was very little detail on any of these. If you think about some of the more sensitive sectors that have been subject to export controls, things like high-end ships and rare earths, there was no resolution on that front.

And then finally, on the geopolitics, which I think a lot of people were thinking about on issues like Iran and Taiwan. On Iran, the U.S. claimed that China shared a common view on Iran, but this was not anywhere to be seen in the readouts from China. And on the flip side, you had President Xi talking about the importance of Taiwan, but no official comment from the U.S.

So I think if you put all of this together, you could perhaps even argue that the outcome was a bit of a disappointment to the low expectations. The best metric of the state of play between the U.S. and China tends to be the Renminbi exchange rate. And if you look at dollar CNY today, it's rallied back above 6.8.

This probably adds a little bit of upside to the dollar near-term, although I think there are other factors that are driving that. And if I think about broader asset prices, I would say limited implications maybe adds a bit to the risk-off tone we're seeing in equities. The key thing here is the U.S.-China detente holds for the time being, and the U.S. has offered President Xi to visit the U.S. in September.

I think it's the 24th of September. We'll see if that trip goes ahead. It's still very far away, but I think the broader implications should be somewhat limited.

Great. Thank you. OK, so if the broader implications are limited outside of perhaps CNY, then update us on how you're thinking about FX broadly.

What are your highest conviction views at the moment? Sure, Mark. So as it happens, our U.S. dollar view is very much aligned with your view on front-end U.S. rates.

The way I think about it is you kind of had this rubber band of pricing in multiple rate hikes by other major central banks, yet very little for the Fed. And that rubber band, in my mind, can only be stretched so much, especially when you look at U.S. data surprises that, by my measure, are at their most positive versus the rest of the world since 2023. So in other words, there's a very big gap between where U.S. rate differentials are versus the rest of the world and where U.S. data surprises are versus the rest of the world.

And I think this gap is not sustainable. So we are tactically bullish on the U.S. dollar. OK, great.

Thank you. Let's also talk about another very relevant FX development. This is more over recent weeks, but certainly can have some global spillovers.

We have seen that Japanese authorities have intervened on multiple occasions in the yen. What has been happening? How do you understand it?

And where do we go from here? Sure. Thanks, Mark.

Just to put it in context, yen weakness is very much a symptom of behind-the-curve policy and especially monetary policy. So keep in mind the Ministry of Finance in Japan, which is responsible for FX intervention, intervened when dollar yen went above 160. But it's not just about the level.

This happened immediately after the Bank of Japan chose not to hike rates at its April policy meeting. And, of course, as Megan was discussing earlier, this is part of the reason we're seeing curves steepen and back-end yields move higher. But a side effect is a weaker yen.

Now, they have intervened quite aggressively. So they've intervened at least four times. And by our estimates, probably the amount has been more than 10 trillion yen, which is about $65 billion US.

That's easily the biggest period of intervention and the biggest amount of intervention this decade. The MOF has been in close consultation with the US Treasury. But there's very little evidence that coordinated intervention is likely.

In fact, Treasury Secretary Besant was in Japan earlier this week. And there was very little indication that they would deliver any sort of coordinated intervention. Now, the reason I mention that is unless you get coordinated intervention, which would be a big surprise, intervention just by the Ministry of Finance, in our view, would not be effective because you're kind of fighting against an external shock that's worsening Japan's trade balance, as well as persistent structural outflows from the corporate sector and the household sector.

That's been our view. And since the intervention, most clients agree. And our FX franchise has seen a lot of buying of dollar-yen whenever you get these dips on interventions.

Now, this is something I fear as well, because I think bearish yen, which is a view we've held for several years, has finally become quite consensus. And we kind of agree with the bearish view on the yen. But you have to keep in mind that at some point, the structural outflow could slow down and you could actually get some influence to Japan to support the yen.

I don't think we're quite there yet. And what you need for that to happen is a prudent policy mix. And by prudent policy mix, I mean not just responsible fiscal policy, but also the Bank of Japan getting on the curve or ahead of the curve and starting to deliver rate hikes, which we think they will from the June policy meeting onward.

Great. Thank you. Okay.

I wanted to transition here to Megan and keep working with that yen intervention theme, because Darsh, as you noted, it's been quite sizable. They're intervening against the dollar. That should have, or in theory, does have spillover effects into U.S. fixed income.

So Megan, what evidence do we have that yen intervention is indeed spilling over into the Treasury market? And what are you watching to get insight into that? Yeah, Mark, there's not a ton of evidence that we see in the official data from the Fed on this yet.

Our yen strategists estimate that intervention flow so far really largely the suspected intervention that occurred on April 30th was about $72 billion in U.S. dollars, which would be one of the largest intervention flows that we've seen in several years. And they think that there's probably $40 to $50 billion in selling flow from Treasuries that was required to fund this. Now, what we tend to look at on the Fed balance sheet side are two line items that we get updated on a weekly basis, some of the most timely data that we get on what the foreign official sector is doing.

But just recall that these are foreign flows on net, so we're not identifying specifically moth flows from this. But if you look at that data over the past couple weeks, we're seeing some decline just in the data that came out last night, about a $23 billion decline week over week. But if you look at over the week before the intervention occurred through what we saw in terms of the data that came out for this week, only about a $10 billion decline.

So really not a lot of data that suggests that the selling flow has been that large. And the other corresponding point here is that if you were to see very significant foreign official sales, we should see some of that pressure in two-year spreads. We should be seeing front-end Treasuries be cheapening.

And if you look at two-year swap spreads since the intervention occurred, front-end Treasuries have been richening. So not a lot of flow that we're seeing just yet. But of course, as Adarsh was speaking to, the question and concern is, can this continue?

And at what level do we think some of this selling flow would become more impactful for the Treasury market? And what I've been telling clients to look at is the big sell-off that we saw in March that corresponded with close to $100 billion in sales from the foreign official sector for what we see from custodial holdings. That likely contributed to the big pullback that we saw in foreign investor demand at auction over the course of March.

March saw that a little bit over 80% of auctions tail more than half a basis point. Some of that was driven by that pullback from foreign investors, perhaps likely foreign official investors, and also contributed to this big buildup in front-end term premium that we saw over the course of March as well. So we'd be looking for something closer to that number to get us concerned.

So far, really not seeing a lot of that big selling flow in the data just yet. We'll just flag to this group too, on Monday, we do get the tick data for March. So that will give us some sense of who was indeed selling over the month of March.

Just notable that we can't really follow the money quite yet, but I know you'll keep watching and I know you're going to get to the bottom of this. So does it really matter for U.S. rates? It sounds like it hasn't cheapened things much.

And then if not, what are the most important things that you're focused on in the rates market right now? And how does that relate to some of your highest conviction views? It's been about the inflation data, the inflation flow, how that fits versus the unemployment rate, thinking about the Fed's dual mandate, right?

This comes back to what our core understanding of Fed reaction function was going to be. If you look back to, you know, kind of rewind back to the March FEP materials, we were seeing the Fed acknowledge the strong tension between unemployment upside risk and inflation upside risk. What have we learned since then?

There's a lot less upside risk to the unemployment rate, given the data that we saw end of last week and more upside risk to inflation from the very strong data flow that we saw over the course of this week. I've been looking very closely at a lot of our consumer data that we get at BofA. The Institute provides phenomenal data on this.

I think it's such a good thing to keep an eye on. It's a bit of a chicken-egg problem. Do we care about consumer first or labor?

But our economists just remind us that you want to be keeping a closer eye on consumer first. A consumer tends to lead labor rather than the other way around. And we have seen still a very robust and resilient consumer.

So far in the first half of the year, some of that may be driven by the fiscal easing that we were expecting to see. But so far, really seeing a consumer that's been able to withstand this upward pressure on gas prices, as we've seen ex-gas spending continues to climb. So what does it mean for the Fed?

Big question here on Warsh and him stepping in what his Fed reaction function is going to be. But to us, it just suggests that the distribution for HICS has to increase. Positioning, I think, has been a bit of a headwind to the capacity for rates to sell off on some of the data flow.

I do think that the market, particularly fast money community, is quite short. We see that in CTA positioning. If you look at active benchmark funds, fixed income funds in the U.S., we also see them underweight treasuries and much more allocated into spread product.

So do think that overall, as I had to say, long or short, much of the market short probably contributed to some of the inertia that we saw with twos at around 4 percent and thirties at 5 percent. But of course, as we're taking in some of these risks around Fed reaction function, global central bank reaction function, the fiscal concerns that are still ongoing, Treasury needing to ramp up supply at some point over the next couple of quarters, and this inflation risk that we're seeing globally, it just creates more upside risks to our rates forecasts. And we continue to like being underweight front end, particularly.

OK, so you mentioned Warsh. He has either already been sworn in or he will be sworn in later today. So we will have a new Fed share.

I know clients are asking about this. So what are the, let's say, two or three most frequent client questions you're getting on Warsh and what is your short response? Sure, Mark.

So the first one hearing that again this morning is when are we going to hear his views? When are we going to hear him talk? We wish we had a better answer on this.

We could hear some remarks at his swearing in. Traditionally, we really don't tend to see a new Fed chair come in and give their views really until their first meeting. We will see whether or not he ends up doing a press conference at the June meeting.

Certainly he has been advocating for the Fed, doing less communication. This is one aspect that we could see Fed chair Warsh change it up in terms of what communication looks like pretty much single handedly. We think changes to the SEP would need much more endorsement from the rest of the committee.

We could get as early as over the next week. That would be pretty unprecedented, but we're hoping to certainly learn more on his views at the June meeting. We also, of course, get his views at Jackson Hole in theory and then also at a congressional testimony over the summer.

So very pivotal to the market and I think is one of the key things that has kept hike pricing relatively at bay in the U.S. relative to other regions is this view that is considering this dual mandate has to be a little bit more cognizant around any quote unquote stagflation impacts that we could see from the labor market. And then also thinking that Fed chair Warsh is going to come in with more of a dovish reaction function relative to what other heads of central banks are viewing right now. The next big question mark is, of course, and you get this all the time too, but what is Warsh going to do on balance sheet?

And I say that there's two things that he could in theory do. One would be shorten the wham of the Fed's treasury holdings. It's probably the easiest thing for Warsh to do at first.

The market impact of that will solely be dependent on how Treasury decides to fund the residual. So this in theory, if the Fed is shifting the wham of their holdings shorter by changing what part of the curve they're reinvesting at, it would shorten the wham of Treasury holdings outstanding. If Treasury decides to push against that and keep wham stable, they would have to then fund more at the long end of the curve.

Our view is that that's not likely to happen. Treasury wham is historically quite elevated right now. They'll probably go with the flow of shorter Fed wham.

And because of a lot of the things that they're considering in terms of the demand base, we're also seeing this from global DMOs as well, that they'll be shifting more of that issuance towards front end and belly of the curve when they do grow auction sizes again. For Fed to actually cut size of balance sheet, we think that the first order event that would have to occur first are liquidity reg changes. And we think that that would be pretty positive for front end spreads, consistent with some of the views that we have on right now in rates and swap spread front.

But any real change for the Fed in terms of whether or not they will be able to shrink balance sheet will come down to whether or not bank CIOs are going to be responsive to those liquidity changes. And what we hear from our contacts and clients is that they're going to be pretty slow to respond to this and have to be quite sure that these changes are here to stay. Great.

Thanks. Yeah. We've often said that we think Warsh and the balance sheet is much more bark than bite.

Thank you, Adarsh. Thank you, Megan. Your insights, especially on what seems like every week is another very informative week.

I really appreciate your perspective. To those over the phone, you probably know, but I will reiterate, regardless, we are always happy to hear your feedback, take your questions. You should know how to reach us.

But I know myself, Darsh, Megan, very available over Bloomberg chat, email, whatever your preferred means of communication might be. So with that, we will conclude. Thanks again for joining.

Everybody have a wonderful, safe weekend. Thanks for joining us today. We hope you found this useful and that you'll tune in next week.

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