The week ahead: FOMC, BOJ and BOE to set the tone

Financial markets will be directed by major central banks this week, with the Bank of Japan, the Federal Reserve and the Bank of England announcing their policy decisions later this week. The BOJ will kick things off on Tuesday, with no change expected from them. The Fed and the BOE are also expected to keep interest rates where they are, however, investors will be parsing all statements from these three central banks, as any hints about what they could do next could set the world alight.

US: a round up

The focus this week will be on the FOMC, especially since the rout in the US Treasury market started after the last FOMC meeting back in September. Since then, the 10-year Treasury yield has surged more than 80 basis points. The yield is hovering around the 4.9% mark; however, it has risen by a further 6 basis points on Monday and remains precariously close to the 5% level that has psychological importance. Some may wonder why the market is so terrified of 5% yields, after all they are merely back at levels that were considered normal before the financial crisis. Also, the bond yield rout has barely left a scar on the US economy. Q3 GDP grew by nearly 5% in the US, driven by a strong US consumer and resurgent business investment. Of course, we don’t expect this pace of growth to last, but even if it was to half, it would still be the envy of most of the world. Thus, perhaps the FOMC needs to signal that US interest rates need to rise significantly higher to ensure that inflation is kept under control. The market currently expects interest rates to have peaked, with a mere 24% chance of a rate hike currently priced in for a further rate hike to 5.5-5.75% by December.  This is down from a 32% chance a month ago.

Stocks rebound at the start of the week

Thus, as growth in the US surges, the market becomes less convinced that a further rate hike is in the wings. Interestingly, the market may be taking its cue not from the economic data, but instead from the stock market. The US’s S&P 500 had fallen into correction territory on Friday, when it declined by 10% from its summer peak, however, US stocks have had a good start to the week and are up more than 1% on Monday. This may be the market trying to salvage the last few days of a bad month for stocks, it may also be a reaction to expectations that the S&P 500 will post its first quarter of earnings growth in a year when the Q3 earnings season ends. McDonald’s also posted a stellar earnings report and profit that beat expectations. The stock market has also been buoyed by news of two mergers between real estate investment trusts or REITS. Realty Income agreed to buy Spirit Realty Capital for $9.3bn, and in the health care real estate sector, Health Peak Properties agreed to merge with Physicians Realty Trust valued at $21bn. This comes after REITS have received a pummelling in the stock market this year. News of the mergers could help to stabilise this sector as we move into the final months of the year.

Inflation expectations could force the Fed

The backdrop for the FOMC meeting remains murky, however, it appears that the market is becoming less convinced that the Fed will have to hike rates again and that the bond market can do the tightening for the Fed. That might be wishful thinking for the market since the Fed’s preferred inflation measure, the core PCE, rose by 0.3% in September, and personal spending also rose by a strong 0.7% last month. Added to this, the 5-year forward inflation expectation rate is at 2.45%, which is above the Fed’s target rate and is at its highest level since 2014. Thus, a dovish Fed could be out of the question, instead we expect the Fed’s Jerome Powell to remain vigilant. The only way the market will be proved right is if the Fed shifts from its current stance of data watching, and instead says that it will set policy based on what the 10-year yield does next.

Declining geopolitical fears for markets

From a market perspective, if 10-year yields continue to rise then it is hard to see how stocks can continue to rally into Christmas. However, in the short term, the markets are trading as if geopolitical tensions are declining, or even reversing, which is not the case. Brent crude is down more than 2.4% on Monday at $86.58 at the time of writing. Likewise, the gold price is down by 0.4% so far on Monday as it backs away from the critical $2,000 per ounce level. Does the market think that inflation fears are receding? Or does it think that a 7.1% rally in the oil price since the Israel- Hamas war is too much? If the fed sounds like it is less concerned about inflation risks, then the gold price could soon rise again, as it would likely become the most coveted inflation hedge around.

FX review: the yen fightback continues

In the FX space, the dollar index is the weakest of the major currencies in the G10 FX space today, even though US Treasury yields are rising. The euro, the Aussie dollar and the yen are the strongest. The Aussie dollar is rising after stronger retail sales and a weaker US dollar helps to lift AUD/USD above the 0.63 lows. The yen is also rising as we lead up to Tuesday’s BOJ meeting. While there is no expectation that the BOJ will change policy at this week’s meeting, there is some expectation that any hint of hawkishness from the BOJ could help the yen to claw back losses clocked up this year. USD/JPY is trading around 149, backing away from the psychologically significant 150 level, there could be further gains for the yen on the back of this BOJ meeting.

What to expect from the Bank of England meeting

The BOE meeting will also see the Bank release its latest inflation report forecasts. The market is expecting another on-hold decision from the BOE, higher for longer is also expected with the Bank unlikely to signal that another rate hike is in the wings. The BOE could signal that it will start to cut rates from next summer, and we expect the BOE to revise its CPI forecast modestly higher on the back of rising energy costs. Due to the expected increase in its CPI forecast, we expect the Bank to say that its policy tightening will work with a lag. For GBP/USD, we would point out that this pair is correlated with US equities, so if US stocks continue to sell off, there could be further downside for GBP. Thus, if you trade GBP/USD this month, watch equities. While we expect GBP/USD to remain above $1.20 for the rest of this year, is there another leg lower in the stock market sell off, then we could see GBP/USD fall back towards $1.18.