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Central Bankers in Pressure Cookers - Global Exchanges

FICC Podcasts Podcasts September 20, 2022
FICC Podcasts Podcasts September 20, 2022

 

In this week's episode, we discuss the key factors facing central banks with meetings this week along with potential outcomes in terms of policy and FX responses. We go through the situations facing the Fed, BOJ, BOE, and PBOC.


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About Global Exchanges

BMO’s FX Strategists, Greg Anderson and Stephen Gallo, offer perspectives from strategy, sales and trading on the foreign exchange market, related financial markets, and the global economy.

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Greg Anderson:
Hi. Welcome to episode 52 of Global Exchanges, a podcast about foreign exchange markets and related issues. In this week's episode, my co-host, Stephen Gallo, and I discussed the key factors facing central banks with meetings this week, along with potential outcomes in terms of policy and then FX market responses. We go through the situations facing the Fed, BOJ, BOE and PBOC. The title of this episode is Central Bankers in Pressure Cookers.

Stephen Gallo:
Hi, I'm Stephen Gallo, a London based ethics strategist. Welcome to Global Exchanges presented by BMO Capital Markets.

Greg Anderson:
Hi, I'm Greg Anderson, a New York based FX strategist. I'm Stephen's co-host.

Stephen Gallo:
In each weekly podcast, like today's, we discuss our perspectives on the global economy and the foreign exchange market. We also bring in guests from the FX industry and from related financial markets, like commodities.

Greg Anderson:
We strive to make this show as interactive as possible, so don't hesitate to reach out by going to bmocm.com/globalexchanges. Thanks for joining us.

Stephen Gallo:
Well, here we are. It's the 20th of September 2022. Greg, as you kind of alluded to in the introduction, we're right at the threshold of a few massively important monetary policy decisions for the quarter, and arguably for the year. So thanks again for joining us if you're a regular listener. In terms of what we're thinking for this podcast, I mean, I can sort of frame the discussion by pointing out that as central bankers debate what to do with their monetary policy stances, one issue they face, which is becoming a bigger nuisance by the week, by the month is the strong dollar. At the margin, a strong dollar helps bring down inflation in the U.S., but it also hurts other countries' efforts to reign in their own rates of domestic inflation. And the strong dollar also brings with it issues related to negative capital and trade flows pictures for a number of currencies.

Stephen Gallo:
Greg, we've been talking about this pretty much all year long. And in a really worst case scenario, it can also lead to various forms of financial stress. We haven't seen much evidence of this yet, but it could be something we have to monitor over the next month or two, Greg. So let's lay out the order of things for today's episode. We're going to start with the Fed ahead of tomorrow's FOMC policy announcement, then move on to the Bank of Japan. And finally, we'll pull in this week's BOE policy announcement, and also add in a few of our thoughts on the PBOC given the recent weakness in the Chinese yuan. So starting with the FOMC, the Fed funds futures curve for the month of September has 80 basis points priced into it for tomorrow. What do you make of this pricing, Greg?

Greg Anderson:
So, Stephen, I think the broad market consensus interpretation is that the 80 basis points is an 80% probability of the Fed hiking 75 and a 20% probability that the Fed hikes by 100 basis points. Personally, I think that the probability of the Fed hiking by 100 basis points is probably less than 10%. So I'll start by saying, I personally think that the easiest direction for the U.S. Dollar over the 48 to 72 hours after the FOMC is mildly lower. In terms of the package of information the DFX market will receive tomorrow, the magnitude of the hike is the most important thing. So if I'm wrong and the Fed does hike by 100, I'm sure that Bloomberg's U.S. Dollar index will hit a new all time high, which is only about 0.2% away. And the Fed's broad nominal U.S. Dollar index will hit a high since 1986.

Greg Anderson:
And although that dollar strength does help with U.S. inflation, as you mentioned, Stephen, I don't think that it's really what the Fed wants. They've got to do what they've got to do though. And at this juncture, given the last CPI print, I think they do have to go by 75 basis points at this time. In addition to the rate move, there are two other items I want to flag. First, I think it'll be hard for the FOMC to achieve unanimity on this one, and a 75 basis point move is really the only one that I think would have a chance of achieving unanimity. But I think it's more likely even with that move, that we would end up with one or two dovish dissenters in one or two hawkish dissenters. And in terms of what does the market do with that? I think the emergence of dovish dissenters is a bit more market relevant than disclosure that we have some real hawks on the committee, because we already know that they've made their views known via speeches and media interviews.

Greg Anderson:
The second issue is the dots. The June set of dots had the median end 2022 dot at 3.4%. And then the median end 2020 dot at 3.8%. And then the median end 2024 dot back down to 3.4%. Again, I think the FOMC has come to recognize that that little curl lower projected rates is a bad idea because it might contribute to an inversion of the overnight rate to the two year rate, which I don't think they want for financial stability reasons. So I think they'll take that curl out of their dot curve. I suspect what we'll see is new median dots that are somewhere in the 3.9 to 4.1% range all the way across the curve. So end 2022, end 2023, end end 2024. However, the Fed fund's futures curve, it already has the Fed funds rate hitting max of 4.5% for the cycle in Q2 of next year.

Greg Anderson:
So if that's all the movement that there is in the dots, I suspect that the impulse is slightly to the downside for the U.S.D. And I guess that's where my bottom line is for event risk. I personally would give roughly a 70% probability to an FOMC that is not quite as hawkish as priced in, and therefore results in the U.S. Dollar drifting a little bit lower. Of course, if I'm wrong, the dollar is going to jump at least a percent and is headed the levels last scene when Ferris Bueller and the original Top Gun were just hitting the big screen to kind of put it into context.

Stephen Gallo:
Okay, Greg, that's a good way to finish off the Fed. I was thinking we had milked every last drop out of that Top Gun reference from our earlier podcast, but you just proved me wrong big time. Okay. On a serious note, let's shift over to Asia and the Bank of Japan also on the docket this week. I've seen a lot of internal interest in the end, Greg, and also the BOJ's reaction function, not just from FX colleagues, but also colleagues in different asset classes, particularly the fixed income arena. And there's certainly a lot of customer focus on it, that we know for sure. So just keeping you in the hot seat, Greg, for a few more minutes, what do you think this week is going to bring for the BOJ? Is this going to be the week that the BOJ finally pulls the trigger on changing the yield curve control target for the 10 year JGB?

Greg Anderson:
I definitely get why people outside of FX have become interested in the yen. This year's range in dollar yen is 25% wide, which is the widest since 1998. And with that, dollar yen has become the preferred proxy trade for FX traders who are seeking to trade global rates via FX. So with regards to your yield curve control question, Stephen, I think the answer is that the BOJ will not scrap the mechanism with current parameters until after Kuroda's out of office. And even if the MOF would like to send him packing, nobody's going to take that big of a swipe at central bank independence when the guy only has about six months left. That's not to say that there aren't good arguments for ending the mechanism, because certainly there are. One of them is yen weakness. And the other is the fact that the mechanism has sucked all the liquidity out of the JGB market.

Greg Anderson:
No 10 year bonds traded in last night's session, that's just remarkable. But here's the thing, we were at the same spot a few months ago, and Kuroda simply said no change in the mechanism with such a forceful tone that liquidity returned and the 10 year JGB yield dropped back away from the 0.25% yield curve control ceiling. I think that Kuroda thinks he can do that again. And actually, probably he can. He can probably influence the 10 year JGB yield just in that fashion. However, it will be tough for him to talk the 10 year yield lower while also trying to talk dollar yen lower. I mean, he'll probably try because that's what Prime Minister Kishida and the MOF want him to do, but it will not work. I mean, I guess it might hold dollar yen in check below 145 for a few days, but I think that ultimately we will break above that level and then kind of rocket towards 149 certainly by the end of the year.

Greg Anderson:
I admit that if I'm wrong and Kuroda does scrap the yield curve control, dollar yen's probably going to dip below 140 on the knee jerk. And I would just say, if that happens, dollar yen becomes just a screaming by, because ending yield curve control is not going to cure Japan's capital flows deficit. And that's the real reason for this year's extreme yen weakness. So, Stephen, I think I am done with the hot seat. It's your turn. Realistically, what options does the Bank of England have for this Thursday? And what do you think they will do?

Stephen Gallo:
The short answer, Greg, is not a lot of options. And I've got to take this opportunity to reiterate my stance, which is that even though the pound is gaining at a reasonably attractive nominal base rate within the G-10 space as these Bank of England base rate hikes come through, you really don't want to own Sterling based assets, I think until it's clear that the balance of payments is healing, core flows are improving, the energy crisis is fully behind the UK, and most importantly, inflation is moving notably lower. So within that mix, considering that most of those forces don't seem to be moving in the pound's favor just yet, there are some painful adjustments for the UK economy, I think working their way through. And as I say, it's not clear that Britain is through the worst yet. That's why I'm in the 75 basis point camp for the BOE this week. That's my own personal opinion, that the bank will move by 75 basis points.

Stephen Gallo:
Look, part of this is driven by the outlook for looser fiscal policy in the UK. Yes, what the Fed is doing is important too. I think the bank doesn't want to fall too far behind the Fed. And that leads me to the sort of third element, which is the currency market angle. Now, on the currency market angle, I think the BOE has a very passive stance towards the exchange rate. The bank, the UK have withstood numerous currency crises in the past, and all the lessons of history point to the bank wanting to let the currency do its own thing as much as possible. Let it float, especially if the exchange rate is adjusting to reflect underlying fundamentals in the balance of payments and relative inflation rates. So in other words, the BOE sees the exchange rate as more of a shock absorber in times like these.

Stephen Gallo:
That said, I don't think the bank wants to do anything to cause extreme volatility in the FX market, particularly on the downside right now. And I think that's what a very dovish message and a 50 or shock 25 basis point rate hike would do this week. It would almost be a signal for FX investors to sell Sterling, so that's why I'm in the 75 basis point camp. So with the cross flow coming from the Fed the day before the FOMC, if we get that mild downdraft in the dollar you're anticipating tomorrow after the Fed, Greg, and the BOE moves 75 basis points with less than 70 basis points priced into the Sterling OIS curve, cable should have a bit of a tailwind behind it a bit later this week. And note that in our last Sterling focused weekly on Monday, I gave an expected one month range for a cable of 110 to 117, so we're centered around 113.50.

Stephen Gallo:
So going into the Fed, going into the Bank of England on Thursday, I don't think this is the best level of be aggressively shorting the pound. I think it's probably you better to wait for higher levels first. Now, if I'm wrong and the bank hikes by less than 75 basis points or less than 50 basis points, which come in really big shock, we will see decent downside in cable. But in the event of a non hawkish Fed, probably the better way to be trading a dovish BOE is by selling Sterling along the crosses. So outside of Europe, Sterling CAD, probably lower. Euro Sterling, higher. Sterling Swissy, Sterling Stocky, Sterling Noky all probably lower and so on.

Greg Anderson:
Thanks for those thoughts on the BOE and GBP, Stephen. So I know it's not really monetary policy, but I'd argue that FX policy is as big of a policy lever for the PBOC as interest rate policy. So I want to talk to you about dollar RMB trading above seven now, and how you think the PBOC feels about that and how you think they will respond in terms of the way that they will seek to guide the FX market going forward? What are your thoughts?

Stephen Gallo:
So, Greg, this is a great question to be delving into right now, because Asian currency moves are becoming more intriguing by the day in my opinion. Look, my interpretation of the price action in dollar RMB, and this is not just over the last week, over the last month or so, it suggests to me, my interpretation is that the trade and a segment of capital flows within the financial account have turned more RMB negative. So the flow as it were is somewhat against the PBOC as it seeks to sort of slow the pace of RMB depreciation. There's very little doubt in my mind that if PBOC had not been using administrative measures to signal a preference for a gradual depreciation of the RMB, so for instance, with the setting of the daily mid rates, then if it hadn't been doing that, dollar RMB, would've blown through the seven figure rather than just drift through it and kind of settle around seven, which is what it's basically doing right now.

Stephen Gallo:
Look, I think the PBOC recognizes the slowdown in trade growth, which is a problem for them on the export side of the balance of payments, because they take in dollars through their exports and we know that the RMB is not a fully flexible or convertible currency. We know things are starting to tie up there on the FX side, because not long ago, they released dollar liquidity on shore by cutting the Triple R for FX deposits with local banks. So that is a signal that things are starting to tighten up on the foreign currency liquidity side. So in this environment, I don't think they have much of a choice but to let dollar RMB drift higher. Greg, you'll know we recently hiked our three month dollar C and H call to 7.12 from the 690s. But at the same time, I wouldn't be surprised if we continue to see local rates, particularly in the offshore market drift higher as PBOC seeks to make it less attractive for specs to be aggressively sure of the RMB.

Stephen Gallo:
I mean, one of the reasons we've seen RMB weakness this year to date is because the bond market has become a lot less attractive to non-residents given how far yields have fallen. So we're seeing some of that risk premium show up in the currency. Look, just to finish off, I'm definitely worried about a handful of Asian currencies near term, Greg, particularly as we continue to see trade data and export orders weaken for that region. But I also think that domestic demand in China is weak enough already that China doesn't have to worry about an acute balance of payments crisis, for now anyway.

Greg Anderson:
Stephen, I think we've about done it. Should we conclude here?

Stephen Gallo:
Yeah. Why don't we wrap up this episode, episode 52 here? We appreciate you tuning in. Until next time, thanks for joining us.

Greg Anderson:
Thanks for listening to Global Exchanges. Listen to past episodes and find transcripts bmocm.com/globalexchanges.

Stephen Gallo:
We'd love to hear what you thought of today's episode. You can send us an email or reach out to us on Bloomberg. You can listen to this show and subscribe on Apple Podcasts, Spotify, or your favorite podcast provider.

Greg Anderson:
This show and resources are supported by our team here at BMO, including the FICC Macro Strategy Group and BMO's marketing team. This show is produced and edited by Puddle Creative.

Speaker 3:
The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.

Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy

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