A Big Week for Central Banks as US Yields Nudge Higher

USD

At the beginning of the current week, the trend seen in previous weeks has somewhat reversed, as investors found relief in the absence of a broader conflict between Israel and Hamas, which had escalated over the weekend. Crude oil prices have decreased by 1% to 2%, and U.S. Treasury (UST) bond yields have slightly risen. Israel has initiated a full-scale invasion of Gaza, and there have been reports of increased clashes with Hezbollah on the Lebanon border, as well as Israeli attacks on targets in Syria. These weekend developments will keep geopolitical risks at the forefront of factors influencing financial markets, especially during a week filled with significant macro events, including three central bank meetings (the Bank of Japan, the Federal Reserve, and the Bank of England), with the week culminating in the release of the October U.S. jobs report.

Among these central bank meetings, the Bank of Japan's meeting today holds the most uncertainty regarding the outcome. Recent speculation about a possible change in Yield Curve Control (YCC) at this meeting was triggered in part by a Nikkei news article. Additionally, there was stronger than expected Tokyo Consumer Price Index (CPI) data last Friday, and Rengo, a major labour union umbrella group in Japan, recommended a wage increase of "at least 5%" for the upcoming Shunto wage negotiations that will impact wage growth in April 2024.

In addition to the central bank meetings and the U.S. jobs report, the U.S. Treasury will announce its quarterly refunding plans on Wednesday, which could significantly affect longer-term yields due to increased sensitivity to bond supply dynamics. The yield curve has experienced bear-steepening, with the degree of inversion shrinking from -105 basis points in late July to -17 basis points now. Over the same period, the spread between the 10-year UST bond and the Bund has widened from around 135 basis points to 205 basis points today, marking the widest spread since just before the onset of the COVID-19 pandemic in early 2020.

The refunding announcement, communication from Fed Chair Powell during the FOMC press conference, and the U.S. jobs data on Friday are the three key events in the UST bond market. Despite the recent inability of the U.S. dollar to strengthen further, the potential for dollar gains remains open until clearer evidence of economic weakness is seen in official data, making the Non-Farm Payrolls (NFP) report critical in this regard.

GBP

I’ve discussed the Bank of Japan (BoJ) and, to a lesser extent, the Federal Reserve (FOMC) meetings in the FX Weekly on Friday. The other significant central bank event to watch is the Bank of England (BoE) announcement on Thursday. While it may be the least critical of the three central bank meetings from a global market perspective, it holds importance for UK interest rates and FX market. An announcement of unchanged monetary policy is highly likely, which should come as no surprise, as the Overnight Index Swap (OIS) market currently prices in just one basis point for Thursday's meeting. With the rate tightening cycle likely at its peak, the focus now shifts to the communication regarding the possibility of a shift towards a more dovish stance in the upcoming meetings. While it may still be some way off for the BoE, most data released since the last meeting in September has indicated weak economic activity. This could lead to a downgrade in the growth projections in the Monetary Policy Report compared to those in August.

The previous 5-4 split decision to maintain the policy rate at 5.25% is unlikely to be repeated this week, with a 6-3 or 7-2 vote being more probable. Catherine Mann and Jonathan Haskel will likely continue to vote for a rate hike. Jon Cunliffe's term as Deputy Governor has ended, and Sarah Breeden will commence her term from November 1st and is expected to vote for the first time. Breeden's comments on the weak economic outlook and mixed signals on wage growth risks in a September speech suggest she is more likely to vote with the majority. Meagan Greene's position is somewhat less clear, and her vote will determine whether we see a 6-3 or 7-2 vote, with her maintaining her September view perhaps leading to a 6-3 vote.

The deteriorating economic data is evident and is likely to be acknowledged by Governor Bailey in the press conference. Three consecutive months of declining employment data (PAYE jobs data) have alleviated concerns about wage inflation, and it appears that housing market conditions have worsened further, with the RICS Price Balance this month reaching its lowest level since the Global Financial Crisis.

This expected acknowledgment of weaker data and indications of reduced wage inflation risks in the labour market conditions are likely to push yields lower. The UK OIS curve has room to adjust lower in the future, with just 25 basis points of cuts by September 2024 appearing too conservative, and a less hawkish communication on Thursday could lead to lower yields in the latter part of next year, resulting in further underperformance of the GBP. For GBP/USD, the key support level is the October low of 1.2037.

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