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Japan Macro

Outlook for natural interest rate: Will BoJ’s estimate rise or fall?

• The BoJ released a working paper on 28 August entitled "Recent trends in measuring the natural rate of interest" (Japanese only; title translated by MUMSS). The estimate of the natural interest rate used in the paper is the same as in the bank’s April Outlook Report.
• The working paper, like the April Outlook Report, explains the characteristics of the estimates of the natural interest rate from six studies. The BoJ currently estimates the natural rate of interest as between -1% and around +0.5%.
• The starting point for any discussion of the outlook for the natural interest rate is the longer-term economic growth rate. If growth should rise, the natural interest rate will also rise. While Japan’s longer-term growth prospects could improve at some point, we believe under the assumption of flat growth that the estimated natural interest rate will range from around -0.5% to slightly above 0% based on the features in the six aforementioned studies.

US Fixed Income: Election price-action vs Fed cuts

Macro View: While substantial progress has been made towards the Fed’s 2% inflation target, labor market data has continued to trend weaker. Benchmark revisions to non-farm payrolls indicated there were 818K fewer employed people in March 2024 than initial data reported, implying an average of around 70K fewer jobs added per month in the twelve months to March. In addition, in August the economy added just 142K jobs and July was revised down to 89K, meaning four of the past five months have seen NFP prints under the breakeven job growth of around 175K. The unemployment rate ticked down to 4.2%, but the Sahm Rule remained triggered, suggesting a recession is near or already in process. As for inflation, many sectors are seeing either price declines are slower inflation, with the exception of the sticky shelter costs. This remains inconsistent with real-time rental price data that has already shown a reprieve.

Fed view: The Fed delivered a neutral-to-slightly-hawkish 50bp cut to kick-off the easing cycle. The 50bp cut (and Powell’s messaging at the press conference) was in line with our out-of-consensus view of a “hawkish 50bp cut” base case (see link). Overall the recent Fed rate cut decision seems like a catch-up for not cutting in July, and also probably driven by the acknowledgement that jobs data has been overstated. Such a Fed pivot to focusing on jobs data more vs. inflation, has been one of our long-standing calls. In our view the US labour data has been showing cracks and cooling for quite some time and that eventually they would need to ease quickly to address it. Meanwhile the path ahead is even more challenging then our call for the 1st cut to be a 50bp reduction. Our base-case scenarios have been split nearly evenly between S1 and S2 where the outcome of the US election can play a roll in the size of the next cut.

That said, if September NFP is borderline flat, to maybe even negative, then the market will keep the odds of another 50bp high in the meeting that takes place right after the election. At a minimum the Fed will deliver two more 25bp cuts, as they have outlined in the SEP dots projections from the September FOMC meeting. Yet, if the data remains in a downtrend into the election and Harris wins, we expect risk-off and the Fed delivering a 50bp cuts (listed as Double Cut in our table). However, given that this election outcome might not be known for days and potentially also contested, it’s also likely that we will not know who is the clear winner by the FOMC meeting date. Hence the November 7th possibility is split between 25/50bp for our base-case. Beyond that, we expect the Fed to slowdown the cuts to the more moderate 25bp a meeting pace.

FX Outlook

The US dollar has weakened notably since the last release of the Global Markets Monthly (23rd July), by 3.2% as the market pivoted to the prospect of more aggressive easing by the FOMC. This was duly delivered with a 50bp cut last week and we see the dollar vulnerable to further weakness going forward, although on a more modest scale than since July. We see the FOMC as likely delivering another 50bps cut and a 25bp cut at the last two meetings of the year in November and December. The OIS market is currently close to priced for that scenario. The scale of dollar depreciation will likely be modest given the prospects of most of the rest of G10 also cutting, albeit probably by less than the Fed. Weak economic data from Europe this week (advance PMIs) has opened up the prospect of an ECB rate cut in October while we see the potential for UK growth to ease after stronger than expected growth in 1H which might open up back-to-back cuts from the BoE. USD/JPY risks remain skewed to the downside despite the rebound from levels below 140.00 after the FOMC meeting with falling yields globally a key catalyst for further yen strength.

USD/JPY - Bearish Bias - 137.00-149.00

EUR/USD - Neutral Bias- 1.0800-1.1400

USD/CNY - Bearish Bias- 6.9500–7.1500

KEY RISK FACTORS IN THE MONTH AHEAD

• One of the main upside risks for USD/JPY would be if Sanae Takaichi was chosen to be the next LDP leader and Prime Minister of Japan. She believes that raising interest rates in Japan is premature and monetary easing should continue. It would become more challenging for the BoJ to continue hiking rates, and as such would encourage market participants to rebuild short JPY positions. At the same time, further cautious BoJ comments over the need for rate hikes in the near-term that place more weight on recent yen gains and financial market instability pose downside risks for the JPY.
• The main downside risks for EUR/USD include: i) the ECB speeding up the pace of rate cuts by delivering another 25bps rate cut in October, ii) a significant escalation in the Middle East conflict that finally threatens to disrupt global oil supply, and iii) a vote of no confidence in the new French Prime Minister before a budget can be passed.
• The main upside and downside risks for USD/CNY are all related to China policies. The rising deflationary risk and downward pressure on the overall economy indicate an urgent need for further policy easing. Positive policy surprises could boost CNY, while a lack of policy support for too long would likely result in CNY giving back some of its recent gains. We expect moderate government policy to help stabilize growth.

European Credit

Following the sharp spread adjustment (20bps widening) between mid-July and early August the credit markets have recovered partially and settled at 8bps wider credit spreads. This is still relatively close (8bps) to the 2 year tights in IG of z107bps. The overall EUR corporate IG index stands now at z115bp, down from z146bp in early January 2024. Overall credit yields have come in since the ECB started rate cuts, to around 3.5%, down from YTD highs of 4.15% in mid-June.

The recent oil prices have been at the lower end of a band at around USD72 and other risk indicators such as Bund-BTP spread has now settled at 134bp, from the June wide of 158bp, and is now close to the 2 year tights of 129bp,from 205bp wides in October 23.

The contrast between the ECB and Fed was brought into sharp focus last week. While the Fed’s jumbo rate cut last week has offered room for other central banks across the globe to loosen monetary policy, Europe has thus far chosen to take a more gradual approach. This came despite Eurozone inflation having slowed in August to a 3 year low of 2.2% and despite Europe facing a greater risk of recession, as marked by this week’s confirmation that this month’s Eurozone Services PMI has fallen to 50.5, putting it on the brink of entering recessionary territory, while the Manufacturing PMI in the region fell deeper into recessionary territory to 44.8.

Political risk has been on the rise in the region, and the sharp collapse in France’s Service’s PMI to 48.3 from 55 is particularly eye catching. Also Germany has also continued to struggle.
Despite this unhelpful fundamental backdrop, European credit continues to benefit from the market’s assumption that a soft landing remains the most likely outcome.

The Main at c.59bp remains close to its two year tight of 50.5bp, if you adjust for the 7bp widening due to the recent roll, but trades well inside its 12month wide of 89.5bp.

We have a neutral/constructive stance on European Banks and retain a cautious stance towards European IG corporate credit at this juncture, with a preference for defensive sectors and higher quality credits over cyclicals and higher beta credits.