Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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ECB’s policy mistake, Bank of Japan comes next
Charu Chanana
Chief Investment Strategist
Summary: The ECB and BOE pushed back on pivot bets, adding to the post-FOMC dollar slide. Markets now expect a higher chance of a Fed rate cut in Q1 compared to the ECB, which could mean that the ECB falls behind the curve. EUR may be a buy on dips for now, but room for 2024 decline has increased. Yen is up over 4% this month on dollar decline, but also on BOJ pivot bets. Next week’s decision could bring another dovish outcome which may bring back yen weakness, especially against EUR and GBP.
ECB could be late to the rate cut party
Unlike the Fed, the central banks across the Atlantic delivered a pushback on pivot bets. The European Central Bank decided to slow PEPP reinvestments in H2 2024, and then stop them at the end of next year. This opened the room to simplify the communication for rate cuts when they happen, but for now President Lagarde said that the Governing Council did not discuss rate cuts. She emphasized that ECB is data dependent, but they are clearly lagging in reading their data. Inflation projections were downgraded to 5.4% from 5.6% for 2023, 2024 cut to 2.7% from 3.2% and 2025 held at 1.9%. However the cut-off date was 23 November, which means that the ECB did not take into account the slide in November CPI to -0.5% MoM. On the growth front, 2023 and 2024 projections were cut with GDP next year seen at just 0.8% with the 2025 forecast held steady at 1.5%.
Going into this week, the big question was whether the Fed or ECB will cut first. Markets were betting on ECB to go earlier than the Fed. But this week’s communication will likely shift that. Markets now price in a March Fed rate cut with 80% probability but a March ECB rate cut has only about 50% odds. This will put the ECB behind the curve again.
For the FX space, this means EUR could be a buy on dips for now as market pricing looks stretched compared to the ECB communication. However, it also means that ECB will have to end up cutting more aggressively in 2024 as they lag behind the curve, and room for EUR decline could be higher. December flash PMIs are a key test today, and a recovery could threaten break of 1.10 in EURUSD. Key resistance seen at 76.4% fibo retracement that lies at 1.1081 ahead of July highs at 1.1276.
Yen at risk of a retreat if BOJ stays ultra-dovish
The Japanese yen has had strong rally, rising by over 4% against the USD in December. But the yen remains a “BOJ problem with a Fed solution”, and gains have come primarily on the back of a slide in Treasury yields. However, part of the strong December gains have also come from speculations around a potential BOJ pivot as early as December or January. BOJ Governor Ueda hinted recently that it will become difficult to keep interest rates negative next year. This pushed the markets to price in odds of a tweak at the BOJ’s December 19 meeting, however he walked back later saying that BOJ officials see little need to end negative interest rates next week.
As we noted in this article last week, we continue to expect BOJ to be gradual and modest with their policy tweak. Pivoting before seeing the wage data could impact their credibility, while waiting too long could mean they will need to tighten policy when other global central banks may have already started to cut rates.
The setup going into next week’s decision will be a tough one for BOJ. After considerable gains this month, JPY will need BOJ to deliver hawkish to sustain the momentum. If BOJ maintains its ultra dovish stance and stays aways from any hints on a potential end of negative rates, that could bring back yen weakness. USDJPY, which closed below its 200DMA yesterday, could move back above the key level around 142.50 and likely move towards 145. Yen weakness could also be pronounced against EUR and GBP, where central banks have stay away from dovish pivots for now.
A low probability outcome could be if the BOJ adds to the speculation on a potential January move, then USDJPY could break below 140 and move into the 137-138 area.
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Latest Macro/FX articles:
Weekly FX Chartbook and Podcasts
11 Dec: Relative Fed and ECB policy messaging to matter more than absolute stances
11 Dec: Macro and FX Podcast: Will central banks, inflation, and PMIs deliver fireworks?
4 Dec: Dovish Fed and ECB bets picking up
4 Dec: Macro and FX Podcast: Key macro data this week, the USD slide ended and gold is on the move
Daily Notes
13 Dec: Fed has a final chance to pushback on rate cut expectations
8 Dec: Exploring the impact of US NFP on different asset classes, BOJ will stick with gradualism
5 Dec: RBA under-delivers: AUD momentum could turn bearish, particularly on the crosses
1 Dec: USD in a dovish fatigue, EUR gives up 1.10, and markets look to Powell
29 Nov: RBNZ needs a reality check
28 Nov: Dollar decline could face tests from month-end flows and OPEC meeting outcome
24 Nov: Japan inflation rebound unlikely to deter Bank of Japan
22 Nov: US exceptionalism still lingers
15 Nov: Peak Fed rates won’t mean end of USD strength
7 Nov: AUD loses ground on RBA’s dovish hike
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