Earnings Call, Conference Presentation, Interview, Fireside Chat
Inflation and the inflation markets
- US Inflation Drivers:
- The recent surge in US headline inflation is primarily attributed to the Iran conflict, with gasoline prices rising to approximately $4.50 per gallon (up from below $3 pre-conflict).
- Tariffs are currently estimated to have added 70 basis points to core PCE inflation; removing tariffs leaves core PCE at 2.5%–2.6% year-over-year.
- AI capital expenditure is beginning to spill over into consumer prices, affecting sectors including electricity, computer software, hardware, and smartphones.
- Supply chain pressures are intensifying, with the New York Fed's global supply chain index reaching nearly two standard deviations above normal.
- Unlike the 2022 inflation surge, current demand-side drivers are weaker; fiscal stimulus is estimated at $140 billion (via the "One Big Beautiful Bill") compared to $2 trillion in direct household stimulus during the pandemic, and labor market tightness is less severe.
- Full pass-through from the energy shock to core inflation has not yet occurred, leading BofA to expect inflation to remain sticky throughout the second half of the year.
- US Federal Reserve Policy Outlook:
- While new Fed Chair Kevin Walsh may prefer to "look through" supply shocks, the Federal Reserve Committee views repeated supply shocks over six years of missed targets as a risk to inflation expectation anchoring.
- The Fed is expected to maintain interest rates on hold until signs of labor market weakness appear or inflation shows sustained resolution.
- The strategists' base case forecasts a 50 basis point rate cut starting in the second half of 2026, bringing rates to 3.125% (estimated long-run neutral rate), contingent on inflation returning to the mid-2% range.
- US Market Positioning & Strategy:
- Market positioning has reversed from a previous expectation of rate cuts, shifting to a stance that is short duration, short rates, and very long risk assets (including credit, MBS, and equities).
- One-year inflation swaps (spot) show a tight correlation with oil price movements.
- Belly forwards (e.g., 1y1y) behave similarly to risk assets and are highly sensitive to equity market sentiment.
- Five-year, five-year inflation expectations remain well-anchored, signaling continued faith in the Fed's long-run credibility despite recent volatility.
- Strategists identify underpriced tail risks regarding prolonged conflict, higher oil prices, and supply chain disruptions that may not be fully reflected in current market pricing.
- Euro Area Economics & ECB Strategy:
- Revised natural gas price forecasts (TTF average of €55 for this year and €37 next year) led to a downward revision in the Euro area inflation forecast.
- The new Euro area inflation projection is 2.9% for the current year and 1.9% for next year; core inflation is forecast at 2.2% this year and 2.1% next year.
- Inflation in the Euro area is expected to peak at 3.3% in Q3 2025, falling below 2% by Q2 2026.
- Despite the softer gas outlook, BofA maintains a forecast for two ECB rate hikes (25 bps each in June and July 2025), raising the deposit rate to 2.5%.
- A delay of the second hike to September 2025 is considered a lower-probability risk, as the cuts were already priced into the March ECB forecast.
- Rate cuts are anticipated to begin in Q2 2027 (quarterly), with the first cut potentially occurring earlier if core inflation peaks and no second-round wage effects materialize.
- United Kingdom Economics & BoE Strategy:
- UK inflation forecasts were lowered by 20 bps for the current year (to 3.3%) and 10 bps for next year (to 2.4%), driven by lower gas prices and weaker-than-expected April data.
- UK headline inflation is projected to peak at 3.7% in Q4 2025, down from a previous 4.1% peak, before falling slightly below target in H2 2026.
- Headline inflation is expected to rise from July 2025 onwards due to rising gas bills and the reversal of temporary declines in airfare and holiday costs.
- The Bank of England is viewed as reluctant to hike further; the forecast for the next rate hike has been pushed from June to July 2025, with a subsequent hike possible in September.
- Inflation Markets & Forward Outlook:
- European five-year, five-year real rates are currently elevated at 92 bps, structurally supporting a bullish stance on European bonds with an expectation that real rates will decline through the summer.
- Counterintuitively, market expectations for end-2027 inflation show greater persistence in the US (+26 bps) and Europe (+46 bps) compared to the UK (+8 bps), despite the UK's historical struggles with inflation persistence.