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Macro - Thoughts on BoJ's short-term rate guidance in post-NIRP world

• What form will guidance of short-term interest rates take if BoJ winds down NIRP?
• We expect Bank will guide uncollateralized overnight call rate -- i.e., risk-free rate -- into positive territory
• Bank may replace three-tiered reserve framework with two tiers and guide short-term rates using fund-absorbing operations

US Fixed Income: Exploring the growing deficits

Macro View: We have entered the non-linear stage of the economic environment where data trends will start to move faster as each month passes. The labour market, which has been the one saving grace for the US economy, continues to shows signs of decelerating with less hours worked per week, slow job gains in the NFP (yet household data continues to show the occasional large monthly decline), the unemployment rate has been rising for over 6 months, and the list goes on. Meanwhile the inflation data continues to improve with the last month’s CPI registering a 0% increase for all items (given the decline energy prices) but even core measures softened versus expectations. Lastly, consumer sentiment remains near the lows and retail spending is starting to soften as well.

Fed Policy: We maintain our view that the last Fed hike for this cycle, when they hiked rates to 5.25%-5.50% range, was delivered at the July FOMC.  If they skip hiking for a third time, we believe that the Fed will need to finally acknowledge that they are on hold at the upcoming December FOMC meeting. In our view they also need to start shifting their focus (given our macro concerns expressed above) to a more balance of risk framework, where growth concerns will increasingly take on an equal focus, alongside their determination of getting inflation down to the 2% target level.

That said, staying on hold in this fast-paced world will be challenging. The higher for longer concept implies that they will not tweak rates. In our view, they need to clarify if higher for longer (HFL) refers to a restrictive level of rates. With neutral rates (r-star) ranging from 2.5-3% for nominal rates, the Fed could cut rates 100-200 bp (the former is our initial estimate of cuts ahead) and suggest that they are keeping rates in a restrictive HFL zone.

Rates View: Our bear curve call has come and gone, but the damage to interest-rate sensitivity sectors of the economy have seen the brunt of it as a result. The 180 swing lower in rates after a one-touch of 5% on the 10yr suggests that the highs are in. So long as the 10-yr stays between 4.375-4.875%, that doesn’t signal a more ominous outlook. A move below the bottom of the range is a bond market signalling a recession is near.

FX Outlook

The US dollar on a DXY basis has weakened notably since the last Global Markets Monthly in October, by around 2.5% with much of that move coming in the last week in the aftermath of the October US CPI print. We had argued previously that there remained a window for dollar strength based on US economic resilience and the “higher for longer” mantra from the Fed that would keep rate hike speculation alive. While the US dollar may recover some ground after this sell-off, the scope for notable gains, say for USD/JPY posting new highs or EUR/USD breaking below 1.0500, are far less than before now. We argued in Q4 2022 that the US dollar bull run had come to an end (after posting a cyclical high in Sept 2022) and we have more conviction in that view now following the recent price action for the dollar. The dollar is over-valued, the Fed’s tightening cycle is over, and a clearer economic slowdown is on the horizon. We must though also caution that sharp US dollar depreciation is also very unlikely given the global growth backdrop is unfavourable for non-dollar FX appreciation.

KEY RISK FACTORS IN THE MONTH AHEAD

• The main risk to our bearish USD/JPY outlook would be if the Fed pushes back more strongly against market expectations for rate cuts next year by indicating concern that financial conditions have eased too much recently. At the same, the BoJ could continue to display caution over raising rates prematurely at the December policy meeting leaving the JPY vulnerable to further selling heading into year end. 
• There risks both to the upside and downside for EUR/USD in the month ahead. As we highlighted above the pair has a strong seasonal bias to rise at the end of the calendar year that could trigger an upside breakout from this year’s trading range between 1.0500 and 1.1000. A stronger signal from the Fed that they have reached the end of their hiking cycle at the December FOMC meeting could also trigger another leg lower for the USD. On the other hand, the main downside risk is that USD weakness is currently overshooting levels implied by the recent change in short-term yield spreads. Continued economic weakness and falling inflation in the euro-zone trigger a reversal of the recent rebound euro before year end. However, the risk of EUR/USD breaking below 1.0500 has diminished reflecting less concern over a broader conflict in the Middle East that could trigger another negative energy price shock for the euro-zone.       
• The upside risk for USD/CNY is China’s slower-than-expected economic recovery, leading to foreign capital flowing out of China’s market. The downside risk is that stimulus packages on Chinese property market produces better than expected results and a quick turn-around of the sector performance likely pressures the pair lower. Moreover, a potential positive surprise may come at December’s China’s high level economic work conference.

European Credit

Credit markets recovered well in recent months with spreads close to the YTD tights, after a short lived autumn widening in October. Central banks from ECB to the FED have halted rate hikes on the back of more benign dynamics in inflation and a relatively benign economic backdrop as inflation is still stubborn. The recent oil prices have been at lower end of a USD75-90 range at around USD75 which is supportive for, what is otherwise a weakened economic backdrop.

High Grade credit continues to be an attractive area for investors, given the mixture of strong underlying fundamentals of the bulk of the members of the index and overall still elevated yield levels, close to multi year highs. The credit spread outlook has been volatile on the back of the continued high rates volatility, albeit this is now seemingly starting to reduce. The situation in Ukraine doesn’t show signs of appeasement and remains a cause of uncertainty, albeit the market has grown used to it. China domestic economic uncertainties, mostly driven by the weakness in the real estate market there, add to the overall volatility in risk sentiment but also here the overall sentiment has improved somewhat. Also the Middle Eastern tensions seem to have peaked for now, adding to a constructive view on IG credit.

As a result, post the October wobble credit spreads have rallied significantly with synthetic indices not showing any signs of respite. Since end October the XO tightened almost 90bps to 379bps (from a March 515bps wide). Pre-invasion of Ukraine XO was in the 320 area. Main is  also 22bps tighter at 68bps following the post CS tights of 66bps in July.