Talking Heads – Une course entre la BCE et la Fed ?

This is an audio transcript of the Talking Heads podcast episode: A race between the ECB and the Fed? 

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing foreign exchange. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by John Bradley, Head of Foreign Exchange. Welcome, John, and thanks for joining me. 

John Bradley: Thank you very much for having me. 

DM: When we think about foreign exchange, central banks are important, as well as economic growth and the inflation outlook. If we look at market pricing now, there’s an expectation of [central bank] rate cuts beginning in March next year, and for a cumulative 125 basis points by the end of the year. What’s your take on the market’s view and what does it mean for currencies? 

JB: We’ve been surprised by the eagerness of the market to price in a ‘soft landing’ scenario, with central banks able to slowly cut interest rates as inflation comes down, but with growth holding up. We think that would create a steeper yield curve in developed markets. Historically, that’s been a market where the US dollar has tended to trade on the weaker side. There’s a good correlation between the dollar and the US interest rate curve –as the curve goes into bullish steepening, the dollar often weakens, especially against the [Japanese] yen.  

The dollar/yen rate is highly correlated with interest rate differentials in an environment where the US Federal Reserve may be cutting interest rates, while the Bank of Japan is possibly hiking rates. That’s the kind of environment where we would expect the dollar/yen to trade on the weaker side over the coming months. 

DM: Can you compare and contrast the [key rate] cuts the market seems to be anticipating from the Fed with the pricing you have seen in terms of expectations for the Bank of Japan? 

JB: Recently, we have seen significant repricing in the front end of the Japanese yield curve. The market is pricing the possibility of a rate hike as early as the December meeting. Looking further ahead, markets are also looking for the possibility of more significant hikes. We currently have about 30 basis points in hikes priced in over the coming year.  

In this environment, the market is also pricing significant cuts from most developed market central banks. So, we think this divergence in interest rate policy is something that could be very supportive of the yen.  

In addition, we have seen a significant move in interest rates over the last month and the yen has lagged. A major build-up in short yen positioning has accrued over the course of the last year as the yen has been used as the primary funding currency, both in developed markets, but also importantly in emerging market carry strategies. So the short base may be forced to cover if we see the yen start to rally. 

DM: Turning to the euro, we’ve seen a significant swing in the views about what the ECB will do, with more chatter about potential cuts in March. What’s your view on how sentiment is changing and the implications for the currency? 

JB: We believe the euro will be a funding currency, both in a possible soft-landing scenario and in a hard-landing scenario.  

In the soft-landing scenario where global growth holds up, there will be a likely funding frenzy as the market moves into commodity currencies and G10 opportunities such as the Australian, Canadian and New Zealand dollars.  

If we see a hard landing scenario, the euro/yen could trade lower as the ECB is more likely to be actively cutting rates, while the Bank of Japan will likely either be on hold or raising rates. So, we see the euro right now as one of the primary funding currencies in the G10, but also as a funder against emerging markets. 

DM: Is it a race to the bottom between the ECB and the Fed if both are expected to be cutting rates? 

JB: That could be the theme. Historically, the Fed has been quicker to react, possibly because of the flexibility provided by its dual mandate. But given how fast inflation is falling in Europe, while at the same time growth remains lacklustre, we see the possibility that the ECB may actually lead the Fed in beginning a rate cutting cycle. That is another reason why having the euro as a funding currency makes some sense.  

DM: How does all this play out with emerging market currencies if we see the Fed cutting rates? 

JB: We think the soft-landing scenario could be ideal for some of the higher-yielding emerging market currencies, specifically Latin American currencies such as Brazilian real and the Mexican peso.  

Those countries benefit from quite high real interest rates, so the central banks are able to cut rates from a position of strength. That should attract inflows into their local bond markets, which will bring rates lower, and into equity markets as well.  

This would all change if the soft-landing scenario doesn’t play out. If we see something that causes more of a hard landing, emerging markets could be fairly vulnerable, especially as their currencies have performed quite well this year. That’s been a popular theme. In the event that we see a hard landing scenario, there could be some de-risking in emerging markets. 

DM: John, thank you very much for joining me. 

JB: Thank you, it’s been my pleasure.