Dagmara Fijalkowski, Head of Global Fixed Income and Currencies, shares her view on central banks and interest rate cuts. In addition, Dan Mitchell, Senior Portfolio Manager, dives into what’s driving the rally in the Japanese Yen.
Watch time: 4 minutes, 58 seconds
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Dagmara Fijalkowski: How have expectations of Fed rate cuts impacted bond yields?
By the time you're seeing this video, the fed will have joined other central banks in cutting interest rates. when they started the hikes in 2022, the objective was to bring inflation back to 2% from levels as high as 9% without, if possible, putting the economy in a recession. While it took over two years, fed governors must be pleased with the results.
So far, so good. The question now is at what pace should fed funds rate be reduced? The July dot plot, which is representing fed governors economic projections showed the median expectation among governors for one cut this year, with the most dovish governors expecting two cuts. Since then, the market went as far as pricing five cuts by year end. There's a big discrepancy between the markets and the fed, and one could argue that the markets have priced too many cuts.
I prefer to think about it, however, as the market weighing two very different scenarios. One, the fed hoped for a scenario of soft landing with inflation falling and growth resilient. That would be justifying two, perhaps three, cuts by year end and subsequent gradual reductions of fed funds rate. The alternative scenario of a recession, with continued and steep increase in unemployment rate, plummeting growth would be necessitating deep and rapid cuts by the fed over the next year, with significant front loading. Market weights the two scenarios and ends up with the unlikely number of 4 or 5 cuts by year end.
As a result, bonds rallied alongside the entire yield curve, with short maturity yields falling more than long maturity yields, leading to the long awaited bullish steepening of the yield curve. The gouges of the economy that we monitor will line up more alongside the soft landing scenario. So our view on bonds in the short term is that the rally has been overdone and the neutral duration stance is warranted.
Dan Mitchell: What is driving the rally in the Japanese Yen?
The big mover in foreign exchange markets this summer has been the Japanese yen. The currency is up 13% since the beginning of July and is now testing its 2024 highs. That's been a very painful move for foreign exchange traders globally, as they've been shorting the yen in order to capitalize on the difference between near zero interest rates in Japan and much higher levels of yields that are available elsewhere in the rest of the world.
So in an otherwise quiet foreign exchange market, we've seen this yen move really offer a jolt to foreign exchange traders who have gotten used to these very tight ranges in FX markets, and we've seen them cut their losing positions in the Japanese yen. Now, there's been three reasons for the Japanese yen gain. The first is we've seen some weaker economic data in the United States, and that's really got the ball rolling on expectations for fed interest rate cuts.
That's undermined the U.S. dollar and led to a sort of broad U.S. dollar underperformance against, a spectrum of emerging market and developed market currencies. Second, the Ministry of Finance in Japan has intervened in currency markets. They bought about 37 billion worth of Japanese yen. And that was enough to sort of change the tide of, negative sentiment on the end.
Third, the Bank of Japan has been hiking interest rates. They've finally abandoned their negative interest rate policy and brought their interest policy rates up to levels that we haven't seen since before the 2008 financial crisis. But even after this 13% rise in the yen, we see the yen is still quite undervalued. In fact, it's the cheapest currency in the world.
And so we expect it to continue to rise and for it to be a major influence on the broader U.S. dollar depreciation that we expect. Overall, we think the U.S. dollar will fall substantially over the next couple of years. We expect the euro and the yen to be the main beneficiaries of that decline. And for the Canadian dollar to lag a little bit, offering only 5% to 6% returns over the next year.