Opinions

We forecast the ECB will raise rates by 25bp at its 10 September meeting, lifting the depo rate to 2.50%. We believe that rising price pressures, owing to the ongoing US Iran war, and the Euro area’s economic resilience, suggest a September rate hike is a done deal. We expect the ECB’s new forecasts to be moderately hawkish (i.e. stronger GDP growth and marginally higher near-term HICP inflation), but for Mme Lagarde to be non-committal and for her tone to be dovish relative to market pricing, as in June. Indeed, with markets pricing three rate hikes by summer 2027, we believe the bar is high to ‘outhawk’ markets. We expect no more rate hikes following the September hike. However, we originally assumed the Islamabad Memorandum would hold. Energy commodity prices have risen markedly since the re-escalation and remain elevated, and markets understandably now price in more ECB rate hikes by mid-2027 than they did on 6 July. We believe if the re-escalation drags on to end-September or end-October, and remains in the range $80-100/bbl, we expect the ECB to hike additionally in December. Also if the price of Brent crude oil rose to above $100/bbl and remained there until end-September or mid-October, the ECB may bring forward its December 2026 hike to October (the October meeting is 29 October). If the re-escalation is resolved by end-September, and the price of Brent crude oil falls back to pre-war levels (in the range $60-70/bbl), we believe September is likely to have been the final ECB rate hike. From a market perspective, we like 2*10 ESTR steepeners at current level of 0.27 with TP at 0.37 and SL at 0.22 & receiving 1yr-1yr ESTR at current levels of 2.95 with SL at 3.10 & TP of 2.75.

As we had mentioned in our 26th Aug report “Jackson Hole: Make or Break for Warsh”, Warsh came out as hawkish as he can to regain the market’s credibility yesterday in his 1st Jackson Hole speech. In a hawkish first Jackson Hole speech as Chairman, Kevin Warsh said that with inflation “running above our 2 percent target,” “the Fed’s predominant focus right now should be on prices.” Warsh characterized the inflation numbers as “concerning” and added that “we must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed… otherwise, we have work to do.” Warsh also struck an optimistic tone on the labor market, characterizing it as “quite stable” and “consistent with full employment,” and noting that the unemployment rate “remains low by historical standards.” The bond market also took today’s speech as hawkish, with a roughly 10bp increase in the 2-year Treasury yield following its release, one of the largest moves around a Jackson Hole speech in recent years. Markets now price the probability of a September rate hike at slightly above 50%, up from roughly 30% before the speech. The 2-10 US SOFR curve sharply bear flattened from 0.20 to .13 by the close of Friday session. Dollar index too rose sharply post Warsh’s speech from 99.15 to 99.70 by the close of today’s session. Our own view is that Warsh was supposed to come swinging uber hawksih at JH otherwise he will have lost credibility. If he had abstained from any forward guidance, long end bond yields will have gone though the roof about which the US treasury is extremely sensitive. So in a way he is Team Bessent only. His speech yesterday means the bar for a hike is not high if inflation surprises on the upside in the Aug reading on 11th Sep. But we believe both core CPI & core PCE might print 0.2% again. Hence we believe Fed is likely to remain on hold for REMCY26 as recent benign inflation data have reduced the degree of urgency to act and has given the Fed the luxury of considering the political calendar, as has been the case in the past. Another important factor is the fact US has not seen interest rate hikes in an election cycle. Since 1990, there has been no hawkish pivot in H2 of an election year.

This year’s Jackson Hole's focus is financial innovation but markets will be eagerly awaiting for Fed Chair's comments on US inflation outlook & Fed's reaction function. Although Warsh has generally avoided anything resembling forward guidance, including clearly articulating his reaction function, markets might expect him to take a firmer stand at JH. During the July FOMC press conference, Warsh said that his Jackson Hole speech looked like a blank piece of paper and that he hadn't decided whether he would deliver a big-picture speech or talk about "the action we're going to have between September and December." If his speech decides to focus on his views about key longer-run drivers of the economy, such as productivity and demographics and their effects on the economy & completely ignores the inflation outlook & resultant reaction function of Fed, long end yields might get unhinged again as markets might further doubt the inflation fighting credibility of Fed leadership. This might lead to bear steepening in US yield curve. If his speech lays out the possible reaction from Fed on elevated inflation prints in next few months, markets might spare the long end bond yields. This might lead to bear flattening in US yield curve. Our own view is Warsh needs to go the extra mile to convince the markets about his inflation fighting credibility. Post the July meeting, the twist steepening was not a result any Fed chair will have desired. Lately treasury's actions on long end yields show they are concerned about bond yield movements. Both has a same solution. Warsh needs to sound clear & firm on what the Fed reaction might be if inflation does not cool down. However, he will likely need to go further than he did in July. Specifically, he may need to state more clearly that price stability means returning PCE inflation to 2% and emphasize that interest rates remain the Fed's primary tool for achieving that goal rather than one of several available instruments. In short, we expect Warsh to signal that he is prepared to raise rates again if inflation does not continue to moderate. Anything less & long end US bond yields might make new highs post JH along with lower dollar.

On the rate front, we expect the BOJ to leave the policy rate unchanged at its 30–31 July Monetary Policy Meeting (MPM). It just recently hiked interest rates in June, and we expect it to adopt a wait-and-see stance at the July MPM while keeping a close eye on the impact of rate hikes to date. We might see two dissents for a rate hike from Board members Hajime Takata and Naoki Tamura. We expect the BOJ to lower its CPI inflation outlook and raise its GDP growth outlook in view of the situation in the Middle East. However, we do not expect the BOJ to change its assessment that the distribution of risks to prices is skewed to the upside. In governor's Ueda press conference, we will be looking for his comment's on BOJ's independence. We expect upward pressure on prices from summer & ongoing rate hikes. Even annual wage negotiations have produced large hikes, including for SMEs. BOJ has been slow in responding to consistently high inflation in Japan. In addition, the fiscal stimulus of current Takaichi administration adds fuel to the fire of higher bond yields and depreciating JPY. We now see JPY staying elevated in 162-165 range if there is no intervention by MoF. We see a terminal rate of 1.5% by H1CY27 against the current policy rate of 1%. We have been bearish on JPY for past few months and remain of the view that without rate hikes being frontloaded, JPY has no saviour.

The FOMC July meeting might see a vigorous family fight between the hawks and centrists. But in the end, Warsh might prevail for a hold yet the FOMC statement might be hawkish. To neutralise the FOMC statement’s hawkishness, Warsh’s press conference might leave enough dovish hints on June favorable CPI prints, low wage inflation & stable market indicators of long-term inflation expectations. From a market perspective, our 1yr-1yr US SOFR 1st half risk risk is received at 4.15 and another half risk waiting to get received at 4.25. This week’s high was 4.23 before it cooled down to close at 4.20. We have a profit target of 3.9 and stop loss at 4.4 for this trade. On the FX side, we continue to believe in DXY strength at least till Sep and continue to see JPY and GBP most weak against DXY. This has played out well till now as JPY is now nearing almost 164 levels & GBP is underperforming G-7 FX due to fiscal worries as well.

We believe the ECB will leave rates unchanged at its 23 July meeting, despite the reescalation of the US-Iran war since 7 July. We continue to believe that ECB will hike by 25 bps in Sep meeting and be done with the rate hike cycle. Markets currently price around 45bp of cumulative hikes in H2 2026; assuming a similar amount is priced going into the July meeting, we would expect marginally less to be priced by the end of the press conference. Recent ECB speak is supportive of a July hold in rates, even by the hawks. We believe that ECB market pricing at any time remains an oil trade. So, if oil continues to trade north of $85-90 levels on Brent in REMCY26, we can’t completely rule out Dec hike. But that is not our base case as of now. We believe Mme Lagarde will urge caution and underscore that uncertainty is elevated, indicating the impact on the Euro area economy depends entirely on the duration and intensity of the conflict, neither of which are clear at this stage. Mme Lagarde will likely want to deliver as neutral a message as possible. We do not have any strong views on Euro as of now but might like to receive 2 yr ESTR around 2.75 levels if available just before the policy event on 23rd July.