BoFA

Fed leads the way, USD to follow

The key message from last week’s ECB central bank forum in Sintra has been the belief that the global economy is entering into a new paradigm of higher inflation which requires a further policy response. For now, taming inflation remains the number one policy objective for all central banks despite further evidence this week of a slowing global economy. Whilst German inflation data was slightly weaker than expectations, the trend throughout the region remains one of rising inflationary pressures. This will, in all probability, elicit a policy response next month but in a world where 50bps rate hikes is the new norm, the ECB (and BoE to a lesser extent) are failing to read the room. This week has seen the Riksbank hike rates by 50bps; we expect the RBA to hike by a similar quantum on 5th July and both the Bank of Canada and RBNZ are also likely to deliver 50bps in tightening. The ECB is being left behind.

ECB President Lagarde’s once again reiterated the ECB’s preference for a 25bps rate hike on 21st July and since hitting the highs through mid-June, German 10yr yields are now 40bps lower. Of more relevance to EUR is the fact that European front-end yields are sharply lower versus G10 counterparts (weighted terms). As the market continues to pair back its expectations for the scale of ECB rate hikes this year, we think EUR is increasingly being left behind in the global rate hiking cycle. Much will obviously depend on the forthcoming Eurozone inflation print but we think that the path of least resistance remains for a weaker EUR through the summer.

Higher USD/JPY remains the ultimate manifestation of the policy divergence trade and this week the pair hit its highest levels since 1998. Shusuke Yamada argues that worst may not be over for JPY as an intransient Bank of Japan remains steadfast in its commitment to Yield Curve Control. He argues that JPY is likely to succumb to further tactical pressure through summer as well as medium-term secular weakness. For now, it seems that Japanese authorities seem content with verbal interventions rather actual. Whilst central banks remain resolute in their desire to rein in inflation, the past week has seen further deterioration in the global macro outlook.

A host of US lead indicators continue to point to a further slowdown in US growth and notwithstanding a beat in China non-manufacturing PMI, global macro data surprises are in negative territory for the first time since last 2021. The Sintra comments suggest that central banks remain on course for further policy tightening through much of this year, but the decline in commodity prices is perhaps a precursor to a more intense debate within central bank circles on the trade-off between combatting inflation and slowing growth. That still seems some ways off which compels us to retain a constructive view towards USD versus much of G10.