Global Rates & FX Views: The great central bank review

Bank of Japan (BOJ) Policy Decision and Market Reaction

• The BOJ raised its policy rate by 25 basis points to 1.25%.
• Market speculation intensified regarding political pressure from Prime Minister Takaichi's appointees, Sata and Asada, who defended the rate hike in press conference materials.
• Following the announcement, the 2030 JGB curve twist steepened as October rate hike expectations were largely priced out, with implied probability dropping to approximately 18%.
• Market expectations have shifted toward a potential rate move in December, where a 25-bps hike remains the consensus baseline.
• The BOJ revised its climate-related fund supporting operations to support financing for climate change responses.
• Changes to fund operations include:
  • Switching the loan rate calculation from prevailing IOER to the average IOER over the loan's outstanding period.
  • Introducing caps on lending amounts, though these are not currently binding (July 2026 loans were ~14 trillion yen vs. 25 trillion yen outstanding).
• These liquidity changes are viewed as incremental steps toward balance sheet normalization rather than immediate liquidity reduction.
• The BOJ's balance sheet is expected to shrink at one of the fastest rates among major central banks, driven by ongoing Quantitative Tightening (QT) and the runoff of fund provisioning measures.

Japanese Government Bonds (JGB) Strategy

• The strategists maintain a constructive and bullish bias on the long end of the JGB curve.
• This view is driven by improving supply-demand dynamics rather than BOJ policy coordination.
• Supportive factors include:
  • Positive sentiment from large investors, particularly major pension funds.
  • Projected decline in net JGB supply relative to nominal GDP in 2027 compared to 2026 due to lower BOJ redemptions.
  • Continued deep buying demand from non-Japanese investors.
• These factors are deemed to outweigh risks associated with narratives of the BOJ falling behind the inflation curve.

FX Market Dynamics (USD/JPY)

• The USD/JPY sell-off was significantly larger than the rate market move implied, attributed to concerns over FX policy credibility rather than monetary policy specifics.
• The defense of the hike by Takaichi appointees challenged the assumption of alignment between the BOJ, Ministry of Finance, and U.S. Treasury.
• While the BOJ hike supports a constructive yen view long-term, near-term FX credibility has taken a hit, reducing appetite for carry trades in the yen.
• The Fed's hawkish stance made it challenging for the front-end to match expectations, though recent price action suggests the BOJ was the primary driver of the immediate USD/JPY move.
• Strategists do not foresee a breakout to new dollar highs against the Euro or DXY basket, citing less divergent U.S. growth fundamentals compared to summer.

Federal Reserve (Fed) Rates Strategy

• Chair Powell's stance indicates policy rates are not currently restrictive, rejecting fixed academic definitions of "neutral."
• The Fed is expected to rely on market signals and financial conditions—specifically equity markets—to determine the path to restrictive policy.
• With equity markets unfazed by pricing an additional ~80 basis points of hikes, the Fed is viewed as having "more work to do."
• Duration views suggest:
  • Front-end rates have room to move higher.
  • The yield curve is expected to flatten as pass-through to longer-term rates remains limited (historically low beta between Fed funds expectations and 10-year yields).
• Three frameworks (Taylor Rule, R-star, SEP unemployment/inflation risks) suggest a terminal policy rate above 5%.

Bank of England (BoE) Rates and QT Strategy

• The BoE signaling moved decisively hawkish compared to July, implicitly pushing back against market pricing of four rate hikes.
• The MPC noted that recent energy price rises must be sustained and big downside data surprises must not occur before further hikes are considered.
• The MPC did not explicitly discuss a four-hike scenario, causing a slight sell-off in the SONIA contract.
• A major market mover was the announcement to stop active gilt sales by the central bank (QT) for approximately six months.
• This pause allowed gilts to rally over 10 basis points, outperforming the SONIA curve.
• The new QT approach shifts responsibility to the Debt Management Office (DMO), potentially using shorter-maturity profiles to better limit the impact on gilt term premiums.
• Net gilts absorbed by the market remain unchanged (20 billion gilts from DMO vs. Bank), but the structural shift is viewed positively for the long end.

Sterling (GBP) Market Reaction

• Sterling weakened against both the dollar and a trade-weighted basket, driven by a drop in front-end gilt yields rather than the gilt curve reaction.
• The FX market failed to react to the positive gilt curve response to the BoE's QT announcement, an atypical divergence given the UK's sensitivity to fiscal risk.
• Despite the short-term weakness, the medium-term outlook remains positive for sterling, particularly versus the euro, due to the potential for lower gilt term premiums.
• The BoE's QT overhaul is viewed as a medium-term structural improvement for the pound.