Global Rates & FX Views: Central banks & budgets

Hello, and welcome to Global Research Unlocked, the Interest Rates and FX Series. This podcast is based on our weekly client conference called, 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 Svia Salim, Head of European Rates Strategy. Today, I'm very happy to be joined by a representative from our Global Economics team. We have Aditya Barve, who is Head of U.S. Economics, Carlos Capistran, Chief Economist for Mexico and Canada. He's only the value head of Japan Economics, Sonali Panani, UK Economist, and Ruben Segura, who is Head of Europe Economics. So we'll talk about all the central bank meetings that we have next week, but also the situation in front, in terms of how DCB will approach it and the UK budget. Before we start, let me remind you that any conflict disclosure related to security discussed on this call can be found in the call invite. With that, let me start with you, Aditya, to cover the Fed. So you have called brilliantly for the September hike. Now you are very out of consensus in thinking they will hike again next week. Markets are pricing in less than 15% chance of that. What made you stick with this call? Right, thank you, Sphere, and good morning. Good afternoon, everyone. Thanks for joining this call. So our conviction is strong that the Fed should hike and pretty low that the Fed will actually follow through and hike rates next week. In terms of the normative case, they started hiking because they were concerned about transit inflation. And although we got some minor downward revisions with methodological adjustments, the biggest story from our perspective is the very problematic September CPI print. It was elevated in top line numbers, but perhaps more importantly, the details were also very discouraging. So once you see that number, we think the Fed should go. Of course, the markets had already priced out an October hike before they saw that number, because Williams and Jefferson, Williams is the head of the New York Fed. Jefferson is the vice chair of the Fed board. And they have both, before even seeing the September data, essentially signal that the Fed doesn't want to go in October. So this from our perspective is very heavy-handed forward guidance. And it raises the question of how you can square this with what should dislike for forward guidance. Either he's not being entirely, either he's not credible on that, or he didn't sign up on the message. And if he really wanted to end the era of forward guidance, he has a great opportunity here to push through a cut. And then going forward, the markets will be sorry, a hike not a cut. And then going forward, markets will be very hesitant to listen to the forward guidance from the Fed. However, if he doesn't, then he's a Fed chair who doesn't want to guide markets, who doesn't want to surprise markets, in which case one would question what his role really is, right? Markets can set policy or the rest of the Fed will have policy via the guidance. So I think he'll be in a tough spot. Now, obviously we acknowledge that it's a heavy lift for the Fed to deliver a hike when it's not in the price. They would be delivering a George to risk assets if they were to hike. And maybe given the wobbles and risk assets, they might not want to do that. So I think the main argument do not go is that it's not in the price rather than, oh, they shouldn't go. We're not really hearing that from clients. Very clear. So if they do not hike next week, what do you think their message will be? I think it will be challenging, right? So worst will obviously be us. Why didn't you hike? And did you endorse the guidance from Williams and Jefferson? On the second one, again, he'll say, no, no, they're free to express their own opinions. And I don't think anyone is going to really challenge them and say, okay, well, then what's your role in all of this? If they've already determined policy for for markets, right? But on the first question of why he didn't hike, I think this is where he's going to have to tap down a little bit because he's going to have to say, look, we focus on trends, we don't focus on individual data points. And he might say something like the trend didn't get worse or the revisions were encouraging or something like that. But look, it's a 35 basis point friend. Yes, it's one month, but we've had several months like this just not so long ago. So how much weight do you want to put on two good inflation trends in June and July, which are already somewhat in the past versus the more concerning news in the last two months, as well as in the year of a year rate. And the risk is, you know, he sounds complacent. Markets were giving the Fed a pass in July as well, right? There were only 10 basis points hiked. But the complacency of his stone as a fast confidence is what caused that very un favorable trade, which was, you know, questioning Fed credibility, steepening of the curve, dollar down, risk assets down. And that's the kind of thing he'll need to somehow try and avoid. And again, it's very difficult to do that without guidance. If you were willing to give guidance, he could say, look, we're pretty much that I'm going again in December or we will continue to hike at whatever steady pace. And I think people will understand that as a quarterly pace of hikes. But that'll be the challenge for him. Yes, talking about the path ahead. Do you think that the moves now in equity markets affect to that path? And what would be your scenario if they don't go next week? Right. So we should not miss the forest for the trees, right? There's minutiae around the timing of Fed hikes. I'm really glad you asked the question. Because big picture, the point is they started hiking and then keep hiking. We have 75 basis points for now. We would stick. Let's say they don't go next week. Then we would move the hikes to a quarterly pace. So instead of September October December, it would be September December March. I think the risks to the upside would increase a bit if they go slower because they run a greater risk of falling behind the curve. In the equity market might smoke them. There's also a little bit of concern kind of under the surface on credit. But all of this reveals to me in asymmetric reaction function, which will mean that the risks are greater that the Fed will go more behind the curve. Because remember, when equities were doing great, but the third year was pushing 5.7%. They said the long end is doing our work for us. And now they're saying, look, we're in the middle of a risk of trade. I think that is what they're thinking. They haven't explicitly said it. But when the middle of a risk of trade, we don't want to cause another wobble in market. It's okay, but the long end is valid. Don't be miscome back down. What about that? It doesn't need to do more. And in isolation, you can say, okay, well, that's a silly argument because this is a broader concern of AI and so on. But when you put that together with the idea that over and raised the higher, that also means they should do less, then no matter what you're arriving at the conclusion that they should do less. And I think that creates a risk that ultimately they fall behind the curve. But it wouldn't materially change our base case. For now, if they don't go in October, we would just say, okay, still 75 basis points just at a quarterly base. Great. Thank you very much, Adita. No shifting to Carlos for the Bank of Canada. You are also going against markets there. But the other way around, so markets are pricing over 80% probability of a hike. And you think the things kind of that will hold. So why is that? Thank you. Good morning, good afternoon, everyone. Look, the market is convinced that the Bank of Canada is going to hike, but the economic case is really not a land down to no. If you look at the economy, the economy remains weak. The output gap is negative. The last two label reports have shown job contractions. Here today, the job market has been contracting. So the economy is clearly, clearly weak. And then when you look at inflation, it is true that headline inflation is above the target. It's a 3.1%. But this is all because of energy prices because when you look at core inflation, unlike the case in the US, core inflation in Canada is below the target. It's 1.9%. So you have a negative output gap, core inflation is below the target. Why would you be fighting? The case for hike is because inflation is above all the target, all prices remain high, the U.S. and the unconfig continues. And this war is the central bank, so obviously they have been very hotish, so they could actually hike. The piece of information that may have changed the balance is that on Monday we got the results from the quarterly surveys that the Bank of Canada and that. And in the consumer surveys, what we saw is inflation expectations move up. So the bank may be worried about that, and it may decide to hike because of that. But again, I think it's not a land of down case from the economic perspective. So I think that actually the risk for that more than 80% that is priced in for, you know, for the decision is actually that the Bank of Canada decides to surprise the market Romanian polls. If they do remain on hold, they are going to continue to be clockish because they are on inflation targeting central bank and inflation is above the target. But I think that they could remain on hold because of the economy and because especially because correlation is below the target. Yeah, thank you on that. And so you're talking about them remaining hawkish and the market have been quite stubborn and pricing and not just one height, but a string of hikes now a hundred basis point implied over the next 12 months. So what do you think can change this variation is on the front end? There are two things that can change that. One is very weak economic data. So I think the fourth quarter we're going to see a weak economy. Remember that the third war between the US and Canada escalated recently. We really have not seen any hard data from after the escalation. But even the data before the escalation as I mentioned has been weak. But I think the fourth quarter could be even weaker than what the Bank of Canada is expecting. So that's one. The second thing that can change market pricing is inflation starts moving down. So this is not going to happen anytime soon. And the central bank even if they remain on hold, the central bank is going to continue to be hawkish. So I think the market is going to continue to keep pricing hikes for for some time. Have you said that even if they hike, I don't see the case for a hiking cycle. I think that if they hike at most they're going to do a couple of hikes just to position themselves a little bit better and try to send the signal that they don't like the inflation expectations moving up and that they are doing something about high high headline inflation. So in any case, I have a high conviction that the market is pricing too many hikes for for Canada. And I think that would remain even if they were to to hike next week. Thank you Carlos. Now shifting to Japan, Izumi. Thank you for staying for this late hour. My pleasure. So for next week, like consensus, you are looking for the BOJ to stay on hold. We have the market pricing in a further 75 to 100 basis point of hikes in the coming year. So do you think the BOJ messaging next week will validate that pricing further out? Yeah, so I think that the messaging at the meeting, whether that's through the outlook report or Governor Wooday's latest post meeting press conference, will support expectations for the next 25 basis point hike being in December. But I think that the BOJ will probably be reluctant to validate a specific terminal rate. So first on the meeting itself, just want to remind everyone we do expect that hold at 1.25%. We would be watching the number of dissents. I think there's a high likelihood that we will get one hawkish descent from board member Takata who would probably propose a hike. But if it's eight one, I don't think that's going to be a surprise. If we get more than one hawkish descent, then that's gets interesting. The key change in this meeting in terms of the communications is the board is going to formally acknowledge that they think underlying inflation has reached the 2% target. But in their view, the reaching the 2% target is not the same as having achieved the target. Because now what they want to see is that underlying inflation stays at the 2% target on a sustained basis. So the key is about stabilization, which matters for the policy stance, because the venture can have been emphasizing concerns around upside inflation risks. Now that underlying inflation is at the target, they really can't tolerate any further overshoot. So I think this leads, this will connect to the governor's communications around the possibility of a December hike. He's not going to explicitly commit to a move in December, but I think he will basically say things that will validate market expectations for such a move, including the fact that price pressures remain strong. Growth is basically evolving in line with the BOJ space case. But in terms of terminal, the BOJ stance is that they really don't know where neutral is. It's probably not 1.25%. And they have been saying financial conditions are accommodative, but they don't have any preconceptions, whether it's 1.75 or 2, or even higher than that. So given what the pricing is right now, I don't think they're necessarily going to push back in a dovish way. And I obviously, concerns around the yen haven't faded. But I don't think they're going to say anything hawkish that will cause a further repricing of hikes. Back to you. Thank you. And more broadly, so thinking about the speed of the hikes and the path ahead, you'll find an interesting section in the latest BOJ financial system report. Today, it's on the resilience of firms to rising rates and the slow transmission of those rate hikes. So do you think this makes for more aggressive tightening or on the other hand, it could actually make the BOJ more cautious because the transmission is slow, so maybe the effect will come later of what's been delivered already? Yeah, so it's a really good question. I definitely recommend anyone interesting to read the report because it has a lot of good analysis. But on that, I do think it sort of validates the faster hiking pace and works more specifically the quarterly hiking pace that we in markets are expecting for the time being. And I do also think that it supports a higher terminal rate at the margin, even though the argument there is less direct. So just to recap, what the key points here are, so their analysis shows that if you look at Japanese corporates, a rising share is effectively debt-free, even amongst companies and particularly SMEs that tend to borrow, things like interest rate coverage and debt ratios have actually improved thanks to the healthy economy. So these stronger finances are helping absorb higher funding costs. And overall, there's a lot more buffers towards rising rates. One very interesting part of the analysis is that if you look at where the maturity of fixed rate borrowings cluster, they cluster around 2030 to 2031. The reason for this is because a lot of firms, particularly smaller enterprises, SMEs, borrowed very long terms at extremely low rates during the COVID pandemic with a variety of publicly supported borrowing programs. So even amongst the most vulnerable borrowers, the reset comes a lot later. So this kind of connects to the DOJ's challenge. One thing that they've been grappling with is that, you know, as I said, they now think underlying inflation is at the 2% target. But the prices, the pace at which underlying inflation has moved up, has not been matched by the pace of removal of accommodation in financial conditions. So overall, the fact that the transmission is slower, that firms have the buffer, I do think support the step up in the hiking pace. And on the margin, it does support a higher terminal, but you're absolutely right, that, you know, just because the, because the. effects are delayed. It doesn't mean that they can just, you know, continue hiking. I do, we do think that they will start to get more cautious as policy rate approaches 2%. So it's, it's more about I think the hiking cases in the near term rather than the terminal for now. Perfect. Thank you very much, isn't me. Sifting now to Europe for Europe. And since the ECB meeting, we did see quite a shift in the tone from ECB speakers and they've been a bit more dovish. So do you think this shift makes sense and do you expect lagard to indeed sound dovish next week? I see, yeah, and I'm thanks for inviting me. Does it make sense? It does. Now, and this is not, at least not mainly about friends. Well, we've seen is a very significant tightening of financial conditions, which accelerated after the September ECB meeting with market pricing a very aggressive cycle with long-term rates moving significantly higher. So it makes sense to sound dovish, to try to regain some control of the narrative. Of course, you're not going to be explicit with forward guidance, but trying to regain some control made sense. I'm thinking about next week, this is a backdrop that of next week's meeting. The ECB is probably aware that if it is to be perceived as hawkish as it was in September, things could easily get out of control. And that to me, alone, probably enough incentive to lean on the side of some dovishness. And I think that's what the ECB is likely to try to deliver. The can do it in several ways, but the simplest ones will be to put a lot more focus on the growth consequences of current developments relative to inflation than that in previous meetings. And we have seen that from a lot of recently, when she talks about long-term rates, when she tried to break declaration between energy prices and policy rate pricing. So I would respect a lot more of that. The other way, and I think this is very important, the other way in the Kallindovie, she's on the back of energy prices that have moved away from their base. I think it's important for the hard to reiterate that we are in a measured adjustment as a scenario, which I always read as a sure-hiking cycle of 75 beeps in total, with some residual risk off of 100 beeps. Among all the central banks we discussed until now, I mean, there was in general talk of a lot, several more hikes, potentially still being priced in by markets, but with this shift in ECB tone, some are raising the question whether ECB may be done here and maybe a December hike may no longer be on the table. What do you think of that? It's nothing, Kallindov. Look, it's very easy to hike on the fear of second-run effects, which is what the ECB is doing. When the economy is vote and vote resilient, and I say vote and vote because to me resilient is a new keyword for mediocre girls. But if you start to see slightly weaker girls and you see something is about to break, then you're not in such comfortable blazing, which you can continue chasing goals and keep hiking on the fear of something that never happens. So, if on the run-up to December, we see activity data deteriorating quite a bit, or we see a couple of bad bank lending surveys and energy prices do not go a lot higher from here, and you're still not seeing second-run effects or a strong indirect effect, I think other is an opportunity for them to skip December and actually to stop the hike and cycle. I want to make it my base case, but I want to put it a zero probability either. Oh, now a big question around fringe spreads. Do you think that them stopping the hike here is what needs to be done to address the widening in fringe spreads or do you expect a new different intervention from them? Also, the big question we're getting is there a specific level at which do you think the ECB will intervene? I mean, the paint threshold is not here, and I always remind of the same, with BTPs at 250 spread, the ECB did not intervene. It's not only about the level, it's also about the speed. The point I would make is that it basically does something initially. It might not be about French spreads, but it's about financial conditions once again on, and that's the third channel in which they could be dovish next week, not in terms of action, but in terms of verbal intervention. Given the market moves we've seen in the last few days, if we continue seeing these volatility, they might need to do a bit more to regain some control of the narrative. I'm more importantly, to avoid something breaking down the line. They come potentially talk about two things, and they're not mutually exclusive. We could get both. I think next week, Lara could select that some of the market moves do not seem fully justified from the mentors, and then she can't remind us that they have tools to address these type of developments. But second, and I think this one is more important, there's been plenty of discussion on whether the ECB will change these soon. I don't think they are going to touch it as structurally. They really believe this can continue going forever and ever, and then you have the structure of the portfolio than the line needing to organic policy growth. What they could do is to flag that if things remain volatile and somewhat disorderly, the ECB could take a temporary pause on QT until market conditions normalize. I think that's the two things we could hear from the ECB next week. A pure question, would they risk of hiking if it's only about French spreads about it? That's what TPI is for. When you hit the paint threshold to trigger a TPI, but if the most in French spread is driven by a brother titling of financial conditions, then yes, that could be another factor in the run-up to December. Great, thank you. We've been finally so long on the UK. It's interesting that the rally and guilds this week contrast very much with the sell-off we've seen in France and Perfrey Bond. It seems that the markets are at ease with the budgetary risk in the UK and comfortable again in considering guilds as safe haven't assets in the current environment. Would you say it makes sense for the market to be this comfortable on budgetary elements heading into next week's budget presentation? Yeah, thanks, Pierre. And thanks for inviting me and good morning and good afternoon, everyone. Yeah, I think heading into just next week's budget specifically to me, this makes sense. Obviously, you know, we've seen fiscal events in the UK have been many a times associated volatility, but this year's budget we think is going to be quite different from that. We expect it to be a fairly low-key event and the government to be in delivering a fairly cautious autumn budget given the fragile bond market. I think the government is aware of the risks that this budget holds, especially given the majority of the global scenario, and they do worry that if they don't deliver a cautious budget next week, then, you know, it does increase just that the UK's position at the current safe haven asset could be in jeopardy. So I think next week in particular, you know, we think the fiscal rules are going to be met. They've said it many, many times that, you know, fiscal discipline is the drug of their stability. So I think that tone is likely to continue. We don't even expect any carve-outs or exclusions from the fiscal rules. So, you know, fairly straight forward there. We do think some flexibility could be used to increase spending on investment in a fairly limited manner via public financial institutions. I think this is something that has been discussed quite a few times. So as long as this is fairly limited, i.e., you know, say three billion a year or something, I think the markets would be able to absorb that. Obviously, the risk is that if they use this flexibility in a more gracious manner and leads to higher gift issuance, that could be something that could be something the markets wouldn't like. But overall, we don't expect that. We expect that if they use this flexibility, it's fairly limited. Clearly, the key measures headroom is likely to be deteriorated to 10 billion as our expectations. But we do think that the government will do correct the fiscal policy to partially restore that post that headroom to 17 billion so we do expect 8 billion of tax rises, whether it's via banks or you know gambling levies etc to be to be announced to in order to kind of restore this post-measured headroom. The budget will also contain some near-term deliver ways to ease somewhat the inflationary pressures from energy but again that's good news because infant does lead to lower inflation that's something that OC is going to be slightly encouraging for the Bank of England. So net net we could potentially get a slight increase in borrowing and even the gross financing requirements for the current fiscal year could be topped up by 10 billion but yeah as you know UK-based strategist is expecting the additional funding requirement to be met via higher team net-table sales which if it all should be bullish for guilds. So net net again a benign budget for next week but for us that doesn't mean that fiscal challenges have gone away from the UK you know next week we you know a lot of the big spending emissions of the new government like defense, social care, unprotected department spending etc that would not be addressed and I guess that is where the risk is it's not where what the budget has but what the budget does not will not have that means that these big emissions are likely to be pushed to later years and but that doesn't mean that they've gone away next year spending review the next year's budget are going to be the key moments where these tough fiscal realities would eventually need to be confronted. Perfect well focus on next week right now but and we also have the BOE not next week but the week after and you are expecting a hike do you think the recent data still supports that comment what do you expect the BOE's overall message to be? Yeah so we are expecting a hike in November followed by a second hike in February the recent data for us just went in the call for the case for the Bank of England now finally starting to hike you know I mean firstly you know their inflation data just keeps surprising the Bank of England forecast to the upside now we do admit that most of the surprise relative to the Bank of England has been driven by energy but underlying services inflation also remains uncomfortably high you know all this while we were seeing some disinflation and underlying services inflation which the Bank of England was saying is countering upside inflation risk from energy but that doesn't seem to be the case anymore. I mean the last couple of friends have seen a tentative pickup in underlying course services inflation and that to me means that you know that sort of domestic disinflation has has has basically stalled but more importantly you know the labour market which is again one of those things that the Bank has pushed said has made the Bank of England a bit dovish all this while that labour market data looks to be stabilizing we see slightly pirating payrolls fall in unemployment which means that the labour market is potentially at the cost of bottoming out and this follows mainly stronger than expected UDP data that we've been seeing this morning the PMIs were pretty good as well and it shows that the economy continues to be a bit resilient and it's fairing better than expected in the middle of horizon energy prices and that's mainly because AI related investments and in activities are helping the UK economy buffer the shocks from the conflict. So at the very minimum this stronger than expected economy does reduce the tradeoff for the Bank of England between growth and inflation and allow them to focus more meaningfully on upside inflation risk but also there's increased the risk that the firms are passed through this energy shock more meaningfully. So adding this all up with rising energy prices and then inflation set to top to 4% in early 27 this clearly calls action in our view from the Bank of England in November but you know we do think that the messaging is going to be fairly balanced I mean they deliver the hike but we think the message would be fairly balanced keeping the hiking bias alive but pushing back against the need for an aggressive and sustained hiking cycle I think you know while data is looking strong you know the usual arguments on second round effects have been that the data has pointing to fairly limited second round effects are from the conflict and you know like last time Billy could say that market pricing reflects the risk earlier that they didn't discuss hundreds of hikes etc etc and we've seen that even the most hawkish member pill has pushed back against market pricing off close to 4 hikes calling it fairly excessive so it's likely to be that you know look we are in a risk management insurance mode you know setting setting the you know the stage for a small and gradual hiking cycle but it may say that you know I think to materialize the market pricing of more than 4 hikes we would really need to see those concrete evidence of that strong second round effect actually materializing not just the risk of it but actual evidence that it is showing up in the data and also a very very persistent energy shock similar to what the NTC had in the adverse scenario which in our view is not obvious case for now great thank you Sonobi and thank you everyone thank you 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