Global Rates & FX Views: Rates and inflation

Eurozone Inflation & Policy Outlook

• September Headline Inflation Forecast: BIA Global Research expects 3.9% year-on-year, significantly higher than the August figure of 3.2% and exceeding the Bloomberg consensus of 3.6% at the time of the call.
• Core Inflation Expectations: Core inflation is projected to remain steady at 2.4% (matching August), with slight upside risk that could push it to 2.5%.
  • A 2.4% figure would constitute a downward surprise relative to ECB projections.
  • Even at 2.5%, core inflation remains compatible with the ECB's September base case scenario.
• Growth vs. ECB Divergence: BIA's medium-term forecasts diverge from the ECB due to skepticism regarding second-round effects and a belief that economic resilience is overstated.
  • BIA forecasts core inflation at 2.3% for next year, which is 20% below the ECB's base case.
  • The firm argues that broadened shocks and tighter financing conditions will constrain growth, preventing an acceleration that would support core inflation.
  • BIA views the "noise" in H1 headline growth data as unreliable compared to the tightening financial environment.

ECB Rate Hike Path

• Base Case Decision: The strategists have penciled in a 25bps rate hike in December as their baseline scenario.
  • This brings the total projected hikes for the cycle to 100bps (four hikes), assuming one additional move after December.
• March Hike Probability: A March rate hike is considered more likely than an October hike, contingent on energy prices and growth dynamics.
  • The likelihood increases if gas and oil futures remain elevated (e.g., near $100/barrel for oil or €50/mwh for gas) beyond the winter season.
  • Conversely, if prices normalize below these thresholds as the heating season ends, further hikes become unlikely.
• ECB Severe Scenario Thresholds: For the ECB to justify more than four hikes (moving toward a severe scenario), oil prices would need to stay above $130 and gas above €70 through 2027.
  • BIA questions the economic resilience if such extreme energy prices persist, suggesting the economy would likely contract rather than accelerate.

European Bond & Inflation Market Dynamics

• Inflation Market Pricing: The market prices a material reduction in inflation to slightly above the 2% target, implying a low-probability upside bias (risk premium) rather than persistent high inflation.
  • The one-year, one-year inflation rate is priced at 2.22%, while the one-year, two-year rate is 2.21%.
• Real Rate Expectations: Markets are pricing in significantly higher real policy rates than BIA expects for the current economic environment.
  • The one-year forward two-year real rate is currently 122 basis points, a level only briefly seen in July 2023 when core inflation was 5.5%.
• Curve Structure Implications: BIA views the implied curve flattening as excessive and mispriced.
  • Nominal rates are pricing in minimal flattening (2-year to 1-year forward flattening from 17bps to 5bps).
  • The inflation curve prices significant steepening (56bps).
  • Consequently, the market implies the real rate curve will flatten drastically from 78bps to just 10bps over the next year, a move BIA deems excessive.

US Inflation & Policy Outlook

• Upcoming PCE Data: Methodological revisions expected next week are projected to lower the YoY PCE rate by approximately 20 basis points.
  • Pre-revision calculations suggest the underlying August core PCE was closer to 3.0%–3.2%, not the reported 3.4%, aligning with Chair Powell's recent press conference comments.
• Underlying Inflation Assessment: BIA estimates underlying US inflation at 2.5% after excluding special factors like Iran sanctions, tariffs, and methodological changes.
  • This figure represents a persistent 50 basis points gap above the Fed's 2% target.
  • The firm notes that underlying inflation has remained remarkably stable over the past year without improvement.
• October Rate Decision Drivers: Inflation trends are deemed more critical for the October Fed decision than labor market data, unless there are drastic signs of labor market cooling or heating.
  • Chair Powell has emphasized a trend-dependent approach rather than being data-point dependent, suggesting a single soft print may not alter the hike narrative.
  • The market currently prices a 70% probability of an October hike.

US Rate Strategy & Trade Views

• Restrictive Policy Stance: BIA believes the Fed aims to reach a restrictive policy rate, with financial conditions playing a key role in achieving this via market tightening.
• Real Yield Curve Position: The firm favors being long forward-starting real-yield curve flatteners.
  • Historical analogies from 2022 suggest that restrictive hiking cycles typically lead to deeper real yield curve inversions than nominal curves.
• Long-Dated Inflation Swaps: BIA has pivoted from being long 5-year/5-year breakevens to being long 10-year/20-year inflation swaps.
  • The strategy is based on the view that longer-dated forward inflation pricing has underperformed relative to equities and oil prices and has room to rise.
  • The firm perceives current forward inflation pricing as overly optimistic, offering a "term premium" opportunity if the Fed fails to fully contain inflation.