The Fed and BOJ are poised to change market sentiment this week

There will be two big central bank meetings this week: the Fed and the Bank of Japan. The Fed is expected to cut rates on Wednesday, the first in a cycle of many. Meanwhile, the BOJ is expected to make no policy changes on Friday, but investors will be paying close attention to what it signals about future hikes.

The implications are quite significant as two notable forces in recent weeks are the steepening of the US yield curve and the strengthening of the Japanese yen globally. Both play a considerable role in the tone of risk assets and could convey critical messages about the state of the global economy.

The market is uncertain whether the Fed will likely cut rates by 25 or 50 bps when the press release hits the news on Wednesday afternoon. The odds are roughly even for the Fed to cut by 25 bps or 50 bps. It’s not often that the market is so divided based on a Fed rate decision. This means any clues from early media outlets like the Wall Street Journal could be taken out of proportion. The decider could come on Tuesday when retail sales data is available, with strong retail sales prompting markets to price in a rate cut and weak retail sales data leading the market to price in two cuts.

Whether the Fed cuts by 25 or 50 bps at this meeting, it seems clear that rates at the front end of the curve will continue to fall, meaning that the yield curve will continue to slope. The 2-year rate is trading about 80 bps higher than the generic 24-month Fed Funds Futures contract. The 2-year rate is currently historically wide against 24-month Fed Funds contracts, suggesting further spread tightening and the potential for the 2-year rate to fall further, which could for the current 2-year rate to be attractive to those. looking to add to bond allocations.

Last week, the 2/10 curve sloped 7 bps, primarily due to the 2-year rate falling faster than the 10-year rate, which is known as a steeper bull. Historically, this happens when the unemployment rate rises as the market begins to anticipate the Fed’s rate cut.

This steepening of the yield curve is likely to continue for some time as the market tries to assess the number of rate cuts needed to bring the overnight funding rate back to a neutral level. Because with the CPI inflation rate falling and the Fed funds rate remaining at 5.33%, the real effective funds rate minus the CPI inflation rate actually rose to 2.8% from 2.45%. This means that if the Fed cuts the rate by 25 bps, the post-cut policy would drop to 2.55%, still leaving it higher than the Fed’s July meeting. That would mean the Fed needs to cut rates by 50 bps to begin easing policy, allowing the real Fed Funds rate to fall to 2.3%.

That’s partly why investors are weighing whether the Fed will cut 50 bps on Wednesday or 25 bps. A 25 bps cut will not ease policy or even leave it stable from where it was in July. In fact, it will allow the policy to remain stricter than before. So given this dynamic, the faster inflation falls, the faster the Fed will have to taper policy, and thus the 2-year rate will continue to fall, allowing the curve to flatten in the coming months.

This steepening of the curve, which ultimately means that rates will likely fall along that curve at different rates, also means that the dollar is likely to continue to weaken against the Japanese yen, especially now that the Bank of Japan is in a rate hike cycle. While the market is not pricing in any rate hikes for this September meeting, the market will be listening to the BOJ and Governor Ueda for clues about the potential for the next rate hike.

BOJ policymaker Junko Nakagawa recently noted that financial markets remain volatile, which has become code word for the BOJ not raising rates at this meeting. However, the general meaning of the BOJ remained with the wording “position to adjust the degree of monetary easing will not change if the economy and prices move in line with the forecast”. This essentially suggests that as long as the economy performs as expected, rates will rise over the long term.

This divergence between the Fed’s and the BOJ’s monetary policy led to lower interest rates between the US and Japan, strengthening the yen. The yen, of course, is a very important funding currency, and when it is weak, traders are likely to short the yen to buy dollar-based assets. When it strengthens, traders will likely sell dollar-backed assets to buy back the yen and return the borrowed yen to its creditors, eliminating liquidity. The removal of the fund’s currency could mean that risk assets that have benefited from cheap yen funding may struggle in the future.

A continued threat of rate hikes from the BOJ in the future is likely to further strengthen the Japanese yen, while the promise of US rate cuts will not only help strengthen the yen, but also tilt the yield curve. Both can have a profound impact because, most importantly, it could be a sign that not only is risk appetite fading, but that the funds that made risk-taking cheap and easily accessible are being discontinued.

This week should only confirm current trends of a steeper US yield curve and a stronger Japanese yen.