Rates, dates, and mixed signals

Markets face quick encounters with the Federal Reserve, Bank of England, and Bank of Japan this week, each offering hints about where they are headed and whether markets should believe what they are hearing. Think of it as a round of central bank speed dating.

The Fed looks to get back into the hiking game. The Bank of England would probably rather not touch rates at all. And the Bank of Japan is taking its time finding the right policy path. That leaves investors to work out where market pricing is the best match and where they may be reading the signals all wrong. Our global strategy team’s take: two hikes and a hold.

The Fed – It’s complicated

Markets ramped up rate hike bets in the aftermath of the August U.S. CPI print. The core gauge coming in hotter-than-expected saw September tightening odds jump to ~90%, leaving the Fed most likely to follow-through with a 25bps rate hike¹. But that raises the question of whether it would be a rare one-and-done or the start of something more.

The answer is not as clear-cut as markets assume. Fed Governor Waller recently remarked that an incremental uptick in month-on-month inflation could still be consistent with disinflationary progress and warrant a policy pause². With the trend of core PCE inflation coming in below what he signaled as a threshold for a hike, markets extrapolating a move this week to a hiking cycle may prove premature.

If the Fed does raise rates this week, as we now expect, it could be seen through the lens of credibility. Fed Chair Warsh signaling that the committee is willing to take action to ensure price stability could in turn help to stem the selloff in long-end Treasuries. That’s as dovish comments of the new Fed chair since taking the helm have led to hiking bets easing but a steeper curve with the long-end coming under pressure³. At a time when the tinkering of Treasury buybacks risks eroding confidence, there is a greater need for the Fed to show resolve.

Either way, a challenging communication event awaits this week. The Fed will need to build on Jackson Hole comments, clarifying its reaction function, to reinstate credibility eroded after whipsawed hawkish and dovish remarks through June and July. A hawkish tone could also prompt markets to anticipate a renewed hiking cycle when pricing through year-end already looks aggressive relative to underlying inflation data.

We remain of the view that the Fed funds rate near neutral will limit policy moves. While energy risks warrant watching, some upward pressure on yields can persist due to a mix of other factors from fiscal concerns to ample AI issuance, keeping us cautious on duration with income opportunities in shorter exposures. 

The Bank of England – Seeing how things go

The Bank of England has been flirting with rate hikes, signaling it stands ready to act should price pressures persist. That alongside a strong relationship between front-end rate pricing and oil prices has underpinned market expectations of a tightening cycle⁴.

Surprisingly resilient growth keeps Bailey and Co. open to the possibility of rate hikes ahead. But the hurdle is rising and we maintain our view for the central bank to keep rates steady through year-end. That’s in sharp contrast to market-implied pricing of more than one hike through December and close to 125bps of tightening over the coming year⁵.

The mismatch rests on rising growth headwinds and limited evidence of second-round price effects. Household energy prices are set to rise again in October, building on a 13% jump in July⁶, further squeezing households. And the UK economy has little capacity to absorb the cost with the labour market remaining soft. Add in the energy shock coming at a time of already elevated fiscal fragility and sharp increases in borrowing costs, and the case for hiking into it weakens.

Bank of Japan – Fashionably late

The bar for the Bank of Japan to surprise the markets is high. Sustained inflation and currency weakness underpinned our expectation for a rate hike this fall. And recent commentary from the US Treasury Secretary has shifted the timeline for the hiking cycle, with a September move now widely anticipated and nearly fully priced by markets⁷.

Beyond the rate hike, markets will be watching for guidance on how policymakers perceive the future policy path. Governor Ueda and Co. maintaining a message that ‘every meeting is live’ is likely enough to stabilize recent swings in the USDJPY, with the currency pair set to settle in a tight range around 152-157.

A more hawkish signal could ramp up rate hike bets, driving further yen strength to the bottom of that range. But politics remain a key factor. Any hints from the central bank on the potential pace of tightening will signal how much flexibility they have against a political backdrop inclined to keep policy accommodative.

Our global strategy team sees another hike in December given a string of strong data, from solid Q2 growth to firm positive wages⁸. While consumption hasn’t followed through from the latter, the backdrop warrants a more aggressive hiking path, with a peak policy rate of 2% likely to be reached next year.

Subsequently, the JGB curve should flatten as monetary policy begins to take a bite out of growth, leaving us tilted towards longer-end exposures. The 10y yield breaking above 3% feels fair, but hard to get excited without confirmation that the BoJ is willing to meet market pricing.

Reading the signals

The week also includes several ECB speakers following last week’s surprisingly hawkish hike. Across the four central banks, the more important question is what policymakers signal about what comes next. Markets are pricing considerably more tightening in some places than data seem to justify.

That leaves us selective rather than uniformly cautious, both on duration and on what is priced into policy curves. We see Fed hikes as likely to be limited rather than the start of a renewed cycle, think markets are pricing too much tightening from the Bank of England, and expect the Bank of Japan to have further to go at a quicker pace. In a week of central bank dating, the best opportunities may be where market pricing and policy rates are headed for a breakup.