Amidst the recent alternation of various factors in the market and the uncertainty surrounding policy and economic growth prospects, global markets closed last week in a state of unease, with investors eagerly awaiting clues about the global monetary policy path from interest rate decisions.
Bloomberg macro strategist Cameron Crise stated: "The recent market turmoil has triggered a narrative backlash from equities to fixed income, and to other market positions. The risk lies in the fact that, in some respects, this time is truly different from what we have experienced before."
Bank of Japan: Unprecedented Uncertainty
Unlike previous market expectations that were overwhelmingly in favor of the Bank of Japan either holding steady or raising rates, this week's interest rate decision is causing more anxiety due to the high level of uncertainty.
Since mid-June, Bank of Japan Governor Haruhiko Kuroda has not publicly discussed monetary policy, marking his longest period of silence before a policy meeting, making it more difficult for the market to predict the interest rate decision. Previously, Kuroda had indicated that "it is highly likely that policy rates will continue to rise, but ultimately it depends on data and information regarding the economy, inflation, and financial conditions." Some Bank of Japan officials are open to the idea of a rate hike this month, as inflation is roughly in line with forecasts. Other officials believe that they can hold off until more data confirms the recovery of consumer spending.
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Surveys show that although only about 30% of Bank of Japan watchers consider another rate hike as the base scenario for this week's interest rate decision, almost no respondents have ruled out this possibility. According to the latest pricing in the swap market on Monday (July 29), investors expected the possibility of a 15 basis point rate hike by the Bank of Japan by July 31 to rise from 25% a week ago to about 50%. Options traders' bets on a rate hike by the Bank of Japan this week rose from below 40% to nearly 90% last week, then fluctuated between the two, highlighting the uncertainty of this interest rate decision.
This high level of uncertainty has led to rollercoaster fluctuations in the yen and Japanese stock market in recent times, which are expected to continue until the announcement of this week's interest rate decision. Ko Nakayama, a former Bank of Japan official and current Chief Economist at Okayama Securities, said, "This week is a tough decision for the Bank of Japan. A rate hike would clearly signal the Bank's strong desire for policy normalization and could also allow the bank to take preemptive action in a context where it does not need to act hastily." Selena Ling, an analyst at Oversea-Chinese Banking Corporation, also believes that the Bank of Japan has a macro background conducive to tightening policy, with recent data showing that Japan's inflation-salary cycle is in a virtuous circle, thus inflation is expected to remain at the target level. Based on this, the Bank of Japan may raise rates by 10 basis points.
Another focus of this meeting will be the specific details of the bond purchase reduction plan. Some analysts say that the Bank of Japan does not want the bond purchase reduction to startle the market, but rather wants investors to have a clear expectation of the outcome. Based on this, the market generally believes that the Bank of Japan's plan will follow the current general expectation of the market, which is to reduce the bond purchase scale from the current 6 trillion yen to 5 trillion yen (32 billion US dollars) per month starting next month, and eventually halve it within two years. It is also worth mentioning that among those market participants who expect the Bank of Japan not to raise rates again this week, the reduction of bond purchases is an important reason. They analyze that for an economy that has not shown significant growth in the past three quarters ending in March of this year, the initial step of quantitative tightening (QT) combined with a rate hike may imply excessive tightening.
For the market trend after the meeting, investors are still most concerned about the yen. After Japan's suspected foreign exchange intervention earlier this month, coupled with rate hike expectations, the yen short positions were significantly closed, and the yen against the US dollar rose from a 38-year low to a more than two-month high within a month. The yen is now at a turning point, which may continue the significant rebound trend of this month or may fall back to a multi-decade low. Especially after only a few hours after the Bank of Japan's meeting, the Federal Reserve will also announce the interest rate decision and release signals about the future policy direction, which may amplify the fluctuations of the yen and Japanese stocks in the Asia-Pacific trading session on Thursday (August 1). Daisuke Karakama, Chief Market Economist at Mizuho Bank, said that this meeting is an appropriate time for the Bank of Japan to raise interest rates, as the recent rise in the yen allows the bank to say that the rate hike is unrelated to exchange rate pressure. He added: "This may also be a key moment for the yen to change from a long-term weak trend." Charu Chanana, Head of FX Strategy at Saxo Capital Markets, believes: "Despite the huge two-way risks, I still lean towards being bearish on the yen. Because for a central bank that is essentially dovish, adjusting the bond purchase plan and raising interest rates at the same time seems to be expecting too much."
Federal Reserve: September Rate Cut Signal More Focused on AttentionFor the Federal Reserve, investors are more focused on signals regarding a rate cut in September than on the interest rate decision itself. Last Friday, the Federal Reserve's most closely watched indicator—the core Personal Consumption Expenditures (PCE) index (excluding volatile food and energy prices) showed that U.S. inflation rose 2.6% year-on-year in June. Although higher than economists' expectations, it was in line with the previous month, recording the slowest year-on-year growth in the index in over three years. Luke Tilley, Chief Economist at Wilmington Trust, said, "This reinforces expectations for the Federal Reserve's first rate cut in September." EY's Chief Economist, Gregory Daco, added, "We expect Federal Reserve officials to engage in a long and intense debate on whether and how to signal a rate cut in September." He believes that the Federal Reserve now has the conditions needed to start cutting rates, "Some policymakers may even agree with us that, considering the current and expected economic conditions, a rate cut in July is also desirable."
Tilley also agrees that recent data supports a rate cut in July, but he emphasizes that the Federal Reserve may still not want to "scare the market." He said that given the market's general expectation that the Federal Reserve will stand pat in July and then cut rates in September, if it were to move up to July, "the market would think, 'The Federal Reserve must know something we don't,' which would have a negative impact. Therefore, the Federal Reserve is expected to remain on hold and signal a rate cut in September."
In the view of James Knightley, Chief International Economist at ING Group, "The upcoming FOMC meeting will lay the groundwork for a rate cut in September, with the Federal Reserve shifting policy from a restrictive stance to a more neutral position."
In fact, recently, both the U.S. bond and stock markets have returned to a "rate cut trade." The Bloomberg U.S. Government Debt Index hit a two-year high this month. By the end of July, U.S. Treasuries will record a rise for a third consecutive month, a situation last seen in mid-2021. The yield spread between 2-year and 10-year U.S. Treasuries has also narrowed significantly, falling to a nine-month low of 14 basis points last week. The U.S. stock market has also begun sector rotation, with cyclical stocks and small-cap stocks catching up, and technology stocks correcting. Albert Edwards, a veteran of Wall Street who has experienced the internet bubble and the 1987 crash, and a well-known strategist at Societe Generale, warned in his latest research report that investors "need to be highly vigilant about the potential for a complete burst of the technology stock bubble." The technology sector currently accounts for about 35% of the total market value of the S&P 500 index, with the "Big Seven" accounting for as much as 30%.
Bank of England: First Rate Cut on the Horizon
There is a divergence in the market on whether the Bank of England will carry out its first rate cut since the pandemic on Thursday (August 1). Since the general election in July, three hawkish members of the Bank of England's Monetary Policy Committee have put forward reasons against loose monetary policy, while only one of the two dovish members has put forward an opposing view. Last Friday, swap trading showed that there is about a 50% chance of the Bank of England cutting rates by 25 basis points this week, with an expected cumulative rate cut of twice this year.
Although the UK's inflation rate has fallen from double digits a year ago to the 2% target, and unemployment is rising, service sector price growth remains strong, and the economy has rebounded from a minor recession. The minimum wage increased by 10% in April, and the new Labour government plans to raise the minimum wage while providing up to 5 million public sector workers with wages higher than the inflation rate, posing a risk of rising prices. Orla Garvey, Senior Portfolio Manager at Federated Hermes, said, "This is an important week, the Bank of England's meeting on August 1 is very timely and will release the latest forecasts."
Regardless, this decision will affect the trend of the pound and UK government bonds. Garvey said that a rate cut would boost UK government bonds. Previously, after the Labour Party won the general election by a landslide, expectations of monetary easing and hopes for political stability have boosted UK bonds. The yield on 2-year UK government bonds is currently at its lowest level in over a year.
For the pound, a rate cut is not so favorable, as it would reduce the attractiveness of the pound as part of a carry trade. The pound is the best-performing currency in the G10 this year, and after recently reaching a high of over a year, the market's bullish bets on the pound have also reached an all-time high. In addition to JPMorgan Chase and Goldman Sachs, which have long been bullish on the pound, Amundi, the largest asset management company in Europe, also joined the crowded trade of being bullish on the pound last week. Andreas Koenig, Global Head of Foreign Exchange at the company, said, "The UK economic environment has improved, the government is relatively stable, and there are many reasons to support the pound." He gave a target for the pound to reach $1.35 by the end of the year, which is a 5% increase from the current level.
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