- Fed and BOJ set to hike. USD/JPY risks tilt down.
- BOE to keep rates on hold and slow QT.
- Canada August CPI to test BOC inflation warning.
The overshoot in Brent crude oil prices above $100 a barrel drove most of last week’s market moves, pushing bond yields higher, weighing on equities, and lending USD modest support. In parallel, sticky US August CPI inflation strengthened the case for a September Fed funds rate hike but failed to justify an aggressive tightening path. USD quickly surrendered its initial gains and finished broadly flat on Friday.
US core CPI rose a firmer than expected 0.3% m/m (consensus: 0.2%) vs. 0.2% in July, while core services less housing CPI rose 0.5% m/m vs. 0.2% in July to be up 3% y/y vs. 2.8% in July. Other measures pointed to a less troubling inflation story but a more worrying demand outlook.
Both the Cleveland Fed median and trimmed mean CPI increased a milder 0.2% m/m. Also, annual core, median, and sticky CPI inflation eased while trimmed mean inflation was unchanged. Finally, real hourly earnings fell for a fifth straight month in August, squeezing purchasing power and creating drag on household spending.
The Fed and BOJ decision take center stage this week, with risks tilted toward a lower USD/JPY.
Fed: Great Expectations
The FOMC is poised to deliver a 25bps hike to a target range of 3.75%-4.00% on Wednesday after five straight holds, marking its first hike since July 2023. Persistently above target US inflation and a stable labor market justify a rate increase.
Fed funds futures price in roughly 90% odds of a hike this week. As such, the vote split, updated Summary of Economic Projections, and Fed Chair Kevin Warsh’s press conference will guide the market reaction.
The futures curve already imply almost 100bps of tightening over the next twelve months: 25bps this week, another 25bps hike by year-end, and nearly 50bps by September 2027. This creates an asymmetric risk for USD with limited gains from a hawkish outcome, but greater downside from a dovish surprise.
Hawkish scenario: a unanimous or near unanimous vote for a hike, dots that align with markets, and/or Warsh signaling more tightening would lift USD.
Dovish scenario: a split vote for a hike, dots below market pricing and/or Warsh framing the hike as insurance against inflation rather than the start of a sustained tightening cycle would weaken USD.
In our view, the US economy does not warrant an aggressive tightening cycle. The slowdown in wage growth is disinflationary, and Fed policy is already somewhat restrictive against a nominal neutral rate of around 3.00%.
BOJ: 25bps Hike Baked In, 50bps Tail Risk
The Bank of Japan (BOJ) is widely expected to raise the policy rate 25bps to 1.25% on Friday after pausing in July. Japan underlying inflation is very close to the 2% target and the economy is running slightly above capacity. A 50bps hike cannot be ruled out as it would help contain inflation expectations, and cap longer term JGB yields.
There is no updated BOJ Outlook Report. That means the vote split and Governor Ueda’s guidance are the focus. Markets will look for indication that another 25bps hike is in store by year-end, and that rates can approach 2.00% over the next twelve months, as implied by the swaps curve. In our view, the BOJ has room to validate this pricing because the policy rate is near the bottom of its estimated 1.10-2.50% neutral range.
Bottom line: risks are skewed towards further JPY gains. A hawkish 25bps hike would extend the rally in JPY, while a surprise 50bps move would supercharge it. The bearish JPY scenario is a narrow majority for a 25bps hike and/or Ueda pushing back against market rate expectations.
BOE Set to Hold, QT in Focus
The Bank of England (BOE) is widely expected to keep the policy rate at 3.75% for a sixth straight meeting (Thursday). Another 6-3 vote is likely with Megan Greene, Catherine L Mann and Huw Pill backing a 25bps hike. Still, easing UK wage growth and services inflation give the BOE room to stand pat. The UK July labor market data (Tuesday) and August CPI (Wednesday) are expected to reinforce that trend.
The BOE is also poised to reduce the pace at which it shrinks its bond holdings (quantitative tightening, QT) in part because of a much smaller volume of maturing bonds in the pipeline next year. We expect the BOE to reduce its gilt holdings rundown from £70bn to £50bn over October 2026 to September 2027. With £30.5bn of maturities due over that period, that would keep active gilt sales broadly unchanged at around £20bn.
Regardless, a slower runoff pace is unlikely to offset the upward pressure on gilt yields from higher energy prices.
The swaps curve implies 125bps of BOE rate hikes in the next twelve months to 5.00%. That’s too aggressive in our view and leaves GBP vulnerable to a dovish BOE repricing. The UK’s negative output gap, a policy rate (currently, 3.75%) already near the top end of the BOE’s 2% to 4% neutral range estimate and the prospect of tighter fiscal policy all argue for a less aggressive hiking cycle.
BOC Braces for Canada CPI
Canada’s August CPI (Monday) will test the Bank of Canada’s (BOC) warning that “the upside risks to inflation have increased.” Headline CPI is seen at 3.0% y/y vs. 3.0% in July, core CPI (ex. food & energy) is expected at 2.1% y/y vs. 1.9% in July, and the policy-relevant core CPI (average of trim and median) is projected at 1.95% y/y for a second straight month. Over Q3, the BOC projects headline CPI at 2.5% y/y, and core CPI (average of trim and median) at 2.0% y/y.
Core inflation above 2% y/y will reinforce the case for a 25bps BOC rate hike to 2.50% on October 28 (currently, 77% priced-in) and offer CAD support. In contrast, core inflation at or just under 2% y/y would leave CAD vulnerable to a modest dovish repricing.
NZ Growth Check
New Zealand Q2 real GDP (Wednesday). Production-based real GDP is expected at 0.1% q/q (RBNZ projection: 0%) vs. 0.8% in Q1. Lower real incomes due to higher prices for fuel, elevated uncertainty, and declining house prices reduced domestic spending and growth over Q2. Encouragingly, leading indicators point to a recovery over Q3.
The RBNZ projects the policy rate (currently, 2.75%) to peak at around 3.25% in 2028, which would still leave it below the top end of its nominal neutral range estimate between 2.3% and 4.1%. The RBNZ cautioned that “spare capacity remains in the economy, particularly in the labour market.” In contrast, the swaps curve implies a policy rate at 4.25% in the next two years. This gap leaves ample room for a dovish repricing which is a drag on NZD.
Beyond the G10
Banco Central do Bazil (BCB) is widely expected to deliver a fifth straight 25bps cut to 13.75% (Wednesday). BCB has room to remove policy restrictiveness as the policy rate is well above the bank’s estimate of the neutral rate (8%, or 5% in real terms). Brazil’s strategic exposure to commodities linked to energy, AI, and defense will continue to bode well for BRL.
Czech Central Bank (CNB) is widely expected to keep rates on hold at 3.75% for a second straight meeting (Thursday). Czech headline and core CPI inflation are stable just under 2% and 3%, respectively. CZK remains supported by an attractive carry and a favorable balance of payments backdrop.
Taiwan’s central bank (CBC) is expected to keep the policy rate at 2.00%, marking more than two years of policy stability (Thursday). A hawkish hold is likely given that Taiwan headline and core CPI inflation are both tracking a little over the CBC’s 2026 projections of 1.9%.
