Policy Derby: Rates for the Roses

Fed Policy & Market Pricing

• The FOMC meeting featured four dissents, the highest count since 1992, signaling a shift toward a more neutral stance and increased nervousness regarding inflation.
• Governor Kashkari's hawkish comments linking oil prices to inflation and the Bank of Canada's explicit threat of consecutive hikes if oil stays elevated have altered rate expectations.
• BofA strategists now anticipate the market may price in at least one rate hike within the next 12 months, potentially driving the two-year rate higher.
• A flatter 2s5s curve is expected as a result of front-end tightening driven by potential Fed action or forward pricing.

ECB Strategy & Rate Outlook

• The ECB has sent an explicit signal regarding hikes in June and July, supported by five specific factors including a unanimous decision to pause while discussing a hike and embedded baseline scenarios for two increases.
• Christine Lagarde noted that even if the war stops immediately, policy consequences will persist, and current market pricing has already done significant work for the central bank.
• BofA analysts maintain a view of two hikes in June and July, with a forecast of "bear flattening" scenarios rather than bear steepening due to the ECB not appearing behind the curve.

Bank of England (BoE) Dynamics

• The BoE's shift to a distribution of scenarios rather than a central case was interpreted by the market as dovish, resulting in an 8-1 vote compared to the expected 7-2.
• Governor Bailey conveyed ample time to assess prospects, ratifying a rate profile significantly more dovish than market expectations prior to the meeting.
• BofA expects BoE rate cuts next year, a view not currently priced in by the market, suggesting the Sonia curve may need to flatten further.
• Risks to the gilt market include local elections, potential leadership changes within the Labour Party, fiscal discipline concerns, and upcoming decisions on the pace of Quantitative Tightening (QT).

Bank of Canada (BoC) Stance

• Governor Macklem signaled a willingness to hike rates consecutively if inflation fails to fall quickly, shifting the BoC's bias from a potential cut to multiple potential hikes.
• Markets have rapidly re-priced to imply two hikes in 2026 and three by the second half of next year, though BofA economists believe the BoC should remain on hold through the year.
• Fundamentals outside of inflation remain unchanged, with anchored inflation expectations and labor market weakness, leading BofA to conclude CAD rates may fall below current market pricing.
• A steeper front-end curve is anticipated if rate hikes are pushed out, alongside a need for the BoC to add permanent liquidity to control money markets.

Bank of Japan (BOJ) & FX Intervention

• The BOJ's failure to hike in April due to government pressure has led to concerns that the institution's independence is compromised and the Takahichi administration lacks policy understanding.
• BofA views the BOJ as behind the curve, forecasting slower hikes, higher break evens, and a steeper curve if rates are delayed until June.
• Recent FX intervention by the Japanese government is seen as a "buying time" tactic that may deplete reserves significantly more than in 2022/2024 due to rising US rates and elevated oil prices.
• Strategists warn that FX intervention alone cannot end Yen depreciation pressure, necessitating a coordinated rate hike soon to be effective.

Reserve Bank of Australia (RBA) Outlook

• The RBA decision next week is viewed as pivotal, with economists expecting a hike in a close vote contingent on weighing upside inflation risks against downside growth risks.
• A hawkish communication regarding second-round inflationary effects could cause the front-end of the Aussie curve to sell off 15-20 basis points.
• Conversely, a cautious "wait and see" approach or a failure to hike could trigger a similar 15-20 basis point rally in rates.

Global Central Bank Plumbing & Liquidity

• A new "Global Plumbing Primer" highlights that while central banks share macroeconomic aims, their balance sheet unwinding strategies diverge: the Fed seeks stabilization, while the ECB and BoE aim for further reduction.
• Supply-driven regimes (Fed), characterized by permanent reserves, keep money market rates closer to the deposit rate, whereas demand-driven regimes (ECB, BoE) keep rates nearer the lending rate.
• The perception of stigma in lending facilities drives some banks toward supply-driven regimes, though this must be weighed against risks of central bank losses and fiscal implications.
• BofA expects a relative increase in dollar reserves versus other currencies, leading to more stable US money market rates and limiting the cheapening of US asset swaps compared to global peers.

Upcoming Treasury Events

• The US Treasury refunding next week is identified as a supply risk event, with expectations for unchanged coupon sizes and focus on forward guidance tweaks.