Tim Graf (TG): This is Street Signals, a weekly conversation about markets and macro brought to you by State Street Markets. I'm your host, Tim Graf, head of macro strategy for Europe. Each week, we talk about the latest insights from our award-winning research, as well as the current thinking from our strategists, traders, business leaders, clients and other experts from financial markets. If you listen to us and like what you're hearing, please subscribe, leave us a good review, get in touch, it all helps us to improve what we offer. With that, here's what's on our minds this week.

Summer is over, and if you were to look only at market price action, you'd think it was all pretty standard affair over the last few months. The volatility sparked by Trump's trade war in early Q2 continued to recede, rates in the US dollar were pretty range bound the whole time and equity markets recovered and finished the month of August basically at all-time highs.

What's kind of weird is how calm markets remain despite some of the headlines of recent weeks. We have a sense that the US labor market, stable but sluggish for the last year, might now be starting to crack all while inflation remains pretty sticky, which is somewhat inconvenient given the Fed seems pretty certain to resume its easing cycle later this month.

Fiscal and political uncertainty are also starting to rear their head again in Europe and the UK and, oh yeah, the ongoing challenges to the Fed and its independence from the Trump administration, those are going to likely continue for the foreseeable future. At least these are all known unknowns and they all might turn out okay. But it still does seem a little odd that risk premia pricing has faded as much and as quickly as it has.

So this week, we catch up with Dan Mazza, head of our FX Forwards Trading business in the US, on why markets continue to show a no fear mentality and how he's positioning himself for the autumn ahead.

Dan Mazza (DM): Hey Tim.

TG: Hey buddy, how are you doing?

DM: Good. On a holiday here, so we're not...

TG: Yeah, no, that's fine. That's my first question. Why are you in on Labor Day?

DM: No, we always are to some degree. We're not like the London guys that take off for US holidays.

TG: Money never sleeps.

DM: I prepped a bunch. I focused mainly on like a lot of this Fed independence and...

TG: Yeah. That's a good place to start, actually. Fed's independence. This isn't actually anything too new. I mean, really almost from day one, Trump's been pressuring the Fed to cut rates. He's put pressure at various times on Jay Powell.

Now we have the news of him trying to fire Lisa Cook. You have him mixed with that. We're going to talk about economic data as well, but some of the pressure on the statistical agencies, particularly after last month's payroll report.

So there's a lot of uncertainty around how US institutions are going to operate. I'm just curious to get your take why we haven't seen a bigger market reaction so far.

DM: We haven't necessarily seen the reaction yet because the Fed is still doing what they should be doing without noise from the administration. So the Fed should probably still be cutting rates. The market seems okay with that. The market seems okay with the Fed getting back to a more neutral rate. These are all things that were already in plan or in progress or things that were going to happen anyway and that the market is currently supporting.

Some people can argue that inflation is still a touch too high. I don't know, we had really, really low inflation for a long period of time. And we didn't think about dropping rates negative in the US. So I think that that's okay to manage in the long term. You know, we had some poor labor data recently. Maybe the trend hasn't necessarily reconfirmed itself.

But I think that in general, the Fed standing on its own and with the market support can cut rates and really nothing's happened yet. We can be concerned about what could be happening or what could happen, but nothing's happened yet.

TG: I guess that's the question is, how concerned are you? There's a lot of speculation over what kind of stacking the Board of Governors means because they sign off and next year, especially they sign off on all the regional Fed president nominations and effectively, they can hack the court.

How big of a threat do you think this is? Or is this a case that the institution won't necessarily bow to his whims anyway?

He can do what he likes, but it's still a stronger institution than him.

DM: There isn't a point in time where the Fed hasn't been involved in some sort of political agenda. We can go back to Truman, Nixon, Johnson. We can go back even further. I mean, the Fed is a political organization. It's created by Congress. So Congress can decide that they want to change how the Fed is structured or how the framework is. All these types of things like it's controlled by Congress, so it is a political body.

But when we talk about the stacking of Fed governors, it still hasn't happened. Either they were placing a lower probability on it happening, or the market is just thinking that the Fed's credibility is above that. You're going to have to put in people that are economists at heart, to some degree, and that that independence will just continue to live on. Or you're really saying, what's 2550 basis points? Does it really matter in the grand scheme of things?

Maybe next year, they decide to cut by too much and the market pushes back. Policy can change again. I think the real trouble is that there's so much going on right now, in terms of tariffs, in terms of a changing economic landscape along a lot of the G7 and NEM countries. That there's a ton going on, so it's hard to see everything through the noise. So it's really about knowing where to look to find out what is actually going on or tell yourself a story of what's actually going on.

TG: Yeah, that actually was kind of the... In the introduction, I talked about all these things that are going on and we'll talk a little bit about Europe. We'll talk a little bit about the UK. You mentioned emerging markets and you of course have these issues in the US. Not just with Fed Independence, but with the data itself that we'll talk about. I mean, what are you looking at to sort of get the signal through the noise?

Because I think that the thing that has struck me is just how well correlated volatility in markets is, whether it's rates, equities or effects, it's all just kind of drifting lower. Everything seems kind of fine. But yeah, as you mentioned, you have all of these things that are at play with each other. And I don't know if it's just that they're canceling each other out or nobody knows what to make of them.

But what sorts of things are you looking at for signals as to how to change a view here?

DM: Yeah. So I think there's a couple of things. I've been looking at the term premium a lot. That's something that's going to be really useful and is going to, I think, have more weight as a couple of different things happen, as our tariff infrastructure, I'll say, in the US, becomes more known.

If tariffs are actually bringing in a ton of revenue, like our administration says that they are, then we're going to see that revenue impact term premium, right? Maybe we do end up issuing more debt in the US. I don't know. So term premiums that I'm definitely keeping an eye on. You talked about volatility. If we want to look at volatility of the bond markets, we can look at the MOVE index. The MOVE index is grinding lower and lower. It's below 80 now. And that's been grinding lower and lower, basically for the most of the year here, after the tariff announcements.

Some other things that I've been looking at, US economic policy uncertainty. So policy uncertainty obviously rose with Trump becoming president this past year. And that really, you know, it rose around election day of the last year, but it's coming off. You know, you look at like a four-week average on that. It's coming off. Like we're kind of through all the tariff noise. And some other stuff that I've been looking at, like pay or skew on the swaps and surface, to see if we're pricing in a higher chance of rates really going up.

And that could be going up for a multitude of reasons. It could be going up for inflationary reasons. It could be going up from term premium reasons. It could be going up for US credit spreads. It could be like there's a million different things that could lead to that surface of richening. But right now, it's pretty well behaved. It's not outside of its normal realm whatsoever. So I don't think there's one silver bullet to look at here.

Like you really have to put together a chart of a bunch of different things, try not to make it confusing and try to see through the noise, because there definitely is a lot of noise. But I think what we're really getting to is we're getting to a point where we're trying to analyze the credibility of the US administration and the credibility of the US Fed. Whether you want those to be separated or the same things, that's up to you, but everybody needs to have that chart on their screen. Like how credible is the Fed? How trustworthy is the administration? How is the market taking this? I don't think anybody wants to be reacting to a moment in the US that would be similar to what we had with the Gilt market a couple of years ago.

TG: Hold that thought for a moment. I just wanted to talk about a bit more about the actual data itself. The Fed looking to ease and the slowing in the labor market, potentially giving them the runway to do that. But last week at the end of the week, we had the initial update and admittedly, it was initial update to the Q3 GDP forecast, which look pretty strong. So you have a possible re-acceleration narrative there.

And I'm wondering how that's playing into your thoughts as far as what the Fed can do. You know, the Fed have all year talked about cutting rates twice, and the market has priced that basically all of this year.

But does this give you any pause in thinking about the health of the consumer?

Let's just take it from that perspective, whether you have, you know, a slowing labor market, but then the consumer that actually might be doing okay. How does that alter your thinking at all?

DM: You said it great, like the plan has been all along for the Fed to cut twice. So why does anything that's in the news or anything change or anything? I'm like, the consumer is doing really well. But I think this is more about the Fed wanting to get rates down to a more normal level. We've argued that the terminal rate is a bit higher than what we maybe were used to.

Maybe we were used to something or the consensus in the market was two and a half to three. Now I think the consensus of the market is more three to three and a half. Getting ourselves down to a more neutral level, I think it is more appropriate.
I think in an ideal world, we're at a neutral level where we're seeing small uptick in growth, and we're seeing small upticks maybe in inflation, but all these things are mean reverting to some degree. The Fed is not going to react to just one number. If we talk about a GDP now estimate on the third quarter, I don't think we should be reacting or trying to overreact to anything like this. We have to look at three to six months’ worth of information, and that's why the Fed is a bit slower, but they want to make sure that they adjust policy when they need to. They don't want to be reacting to one-off data.

So yeah, I think that the consumer is strong, but this is more about getting down to a closer to the terminal rate. Like one cut in September is not going to get us there. They could be wrong. Like central banks have been wrong in the past and have re-hiked rates because inflation has re-spiked. That happened to the ECB. So it's not out of the question that they could also readjust in the future.

TG: Yeah, and Trump has said he's fine with them hiking rates. If inflation re-accelerates, he'll happily see rate hikes after the cuts, of course.

DM: Right, we'll see.

TG: The positioning side of this and how you're thinking about the dollar on this, because that of course has been one of the other big adjustments that's been made over the last six months is, you know, institutional investors that we track, of course, have gone into or went into the year very long at dollars. They're now very short at dollars.

And thinking about how the dollar trades from here, I think, is really interesting in light of all of these mixed messages that we've talked about in cross currents, but also the fact that the consensus now has changed for dollar weakness, anticipating dollar weakness. This for me is, I guess, the big market question because a lot of things have kind of pivoted around the dollar this year.

Do you think we've seen the worst of the weakness?

DM: At the moment, dollar rates, like the move in dollar rates has started to happen. I mean, the Fed's priced in for, let's say, 100 basis points of cuts in the next year. That move has already happened in Europe to some degree, like Europe's on hold. They're still doing QT, but they're doing it at a lower rate. There's been a lot of change in G7 interest rates. Dollar weakness was an adjustment. It was adjustment to policy uncertainty. So we saw, like I said, we saw a huge spike in policy uncertainty. I think that that played through the dollar. You have seen an increase in term premium. You're seeing that come out of the dollar. You are seeing a couple of things that are leading to dollar weakness.

I also think, like what we saw at the beginning of the year, we talked about domestic hedge ratios. The US domestic hedge ratio has really changed. So what we're saying is we're seeing US investors hedge less of their foreign assets. I think that's a big change and that's something that obviously investors are thinking about. Investors are thinking, hey, I don't need to hold these foreign assets currency hedged. So they're holding them in foreign currency. And maybe that's a lowering of the confidence of the dollar. Maybe that's also them saying that, hey, we think the Fed is going to cut at some point and we think their rates were too high. So they're building that into their forecast.

So, yeah, I mean, a lot of that is priced in now, right? We're now in September, we're weeks away from the Fed cutting rates. Could that be a larger cycle than we anticipate? I don't know, but I think from a DXY standpoint, I think that it's at a place now where it probably harbors in this range for a little while, unless we see some other catalysts.

TG: You mentioned the hedge ratio data, which I think has been another big talking point for us, especially, of course, this year, given we have the estimates that we talked about. But one thing that hasn't moved is the foreign investors' willingness to hedge US assets to a greater degree. As you mentioned, a lot of it has been US asset owners hedging less of their foreign asset exposure, as opposed to foreign asset owners hedging more of their dollar exposure.

Have you caught this to any extent in the forward book of maybe foreign institutions through the desk flow that you see, as opposed to the broader institutional flow? Has that been a theme that's picked up that you've seen at all?

DM: I like to try to notionalize these hedge ratios in my head. So the US domestic hedge ratio, in my mind, is going to have a pretty large impact. That's a big investor base. When you see large changes in that, like we saw this year, that's going to have a large notional impact on the market. I think European-based investors or non-U.S.-based investors, when you start to talk about their US assets, if they're an international investor, those impacts might be a bit smaller.

But in terms of what we've seen on the desk here, we have seen some, I'd say, some pretty consistent hedge ratios. We've seen definitely some increase in European money managers and non-U.S. money managers increasing their hedges. It's just really hard for us to understand if that's increasing the market values, right? If they're keeping the hedge ratio constant and increasing the market value. So it's really hard for us to decipher that on the desk. And we really rely on the hedge ratios to help us to see that. And then to take it a step further, we then try to notionalize those impacts.

TG: Well, let's talk about the European side of things. And while we're at it, let's cover the UK as well, because what was interesting you brought up was looking at the skew on rate options and whether upside risks to rates were being priced in the US to any greater degree. I'm wondering if you've done a similar set of analysis for the UK and for Europe, because when it comes to term premia and deficits and who's going to buy the bonds, that's not just a question for treasuries, of course.

It's a question particularly of note in France at the moment where spreads have widened out and now you have OAT spreads to boons similar to what BTP spreads, Italian bond spreads to German bonds are. And so I'm wondering if you have thoughts there and what you're noticing. And is that at this point, the bigger risk in terms of looking at term premium than the US related factors in your mind?

DM: I've been more paying attention to the peripheral spreads there. And like you said, you know, France to Germany yields are, you know, around 78, 80 basis points with Italian yields just a touch above. I don't necessarily think that that's a, that we're in any sort of crisis mode. Maybe we're in the more concerned territory of markets starting to pay attention to that. It's my understanding that it's a more localized France story.

So if the risk is really going to be more contained to France, is that going to have a broader impact on the euro or on the eurozone in general? So I think that that's why it's kind of, I don't want to say flying under the radar, but maybe not getting the attention that some people would expect. And I'm kind of thinking it's contained right now. Like we're not talking about a PIIGS type of movement that we would have been more used to, you know, 10 years ago.

TG: Would you extend that kind of relaxed tone to the UK? Given its fiscal history is a little bit dodgy over the last few years, have a central bank that's in the process, as you mentioned, they're selling bonds at the moment.

Does that worry you at any more than what you've talked about with Europe?

DM: I think that that's the thing, that the UK is really straining its whole, maybe I'll say liquidity framework at the moment. You know, they're selling bonds, they have interest rates that you can say are on the higher side. They have some inflation concerns still. You can read through some of that data maybe if you really wanted to. But you also have like just a ton of gilt supply. The fiscal borrowing is really high. So I think there's a lot of strains right now from the fiscal side in the UK. I'm really not sure my opinion on sterling at the moment.

Like we tend to have a negative bias on sterling. But at the moment, it's just been one that I've been a little bit too unsure on. Because I think that it's been remarkable how the Bank of England has been able to keep rates so high and the economy hasn't broke. Maybe we're more at a tipping point there and people aren't really paying attention to it again. Like I feel like it's like the UK is sensitive to that and the fact that what we saw with the trust guilt moment was that it snuck up on us. The market wasn't ready for it.

Maybe it's global role in terms of like global GDP has decreased a bit or the perception has decreased a bit and that's why we tend to, or the market's tending to ignore it at the moment. And it's not like everyone has a dashboard of what's going on in the UK. When I first started trading, people were trading short sterling and it had its nickname as the widow maker for a reason.

TG: Yeah, the short sterling bias is one I think we also have subscribed to and it's been very, very tricky. You get it right here and there and then it's a pretty disappointing trade overall being short sterling when you have the inflation dynamics that you've talked about and alluded to keeping rates high.

But actually on that note, just to finish up here, the Bank of England is priced to do very little for the next year. The ECB is priced to do very little for the next year. The Fed, as we've talked about, priced a couple of times this year, a couple of times next year probably. Those three central banks were beyond that in G7 or G10 rates. And currency, let's throw that into the mix as well.

What's your gut feel as to whether it's the ones I mentioned or another one, the most mispriced, the biggest opportunity, say for the rest of this year? Now, the summer period is over. We've got three or four months of activity to go before year end.

Where do you see the greatest opportunity within that set of markets?

DM: It's funny, I say that I've been trying to stay away from UK rates, but I can't. I think from a relative standpoint, it could move the most. It really could move the most. And what's offsetting that is some of the like, like I talked about liquidity issues or fiscal constraints, where people are afraid that there might be a bit of a funding moment there. And to be honest, I like playing it against US rates.

US rates already have a bunch of cuts priced in. A lot of people are arguing that it's not warranted, that the inflation story is still there. So maybe there is more of a chance of a policy error if we follow through with four cuts that we have to come back and the Fed has its own kind of like Trudeau type of moment. I think that that's where the biggest opportunity is.

The Bank of Japan is pretty well set here. I don't think you're going to really get much more out of the SNB. The ECB has kind of had its move here. The Bank of Canada mostly has had its move. So, the Bank of England is the one that can surprise us and tends to be the one that surprises me.

TG: Well, it's a lot to think about for the rest of the year. We'll check back in probably start next year, see how we did, see what you think then. But Dan, on your day off, appreciate you taking the time to have a chat and to catch up.

DM: Sounds good. Thanks a lot, Tim. Thanks for having me on.

TG: Thanks for listening to Street Signals. Clients can find this podcast and all of our research at our web portal, Insights. There, you'll be able to find all of our latest thinking on markets where we leverage our deep experience in research on investor behavior, inflation, media sentiment and risk, all of which goes into building an award-winning strategy product. And again, if you like what you've heard, please subscribe wherever you get your podcasts and leave us a review. We'll see you next time.