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.

Lee Ferridge (LF): The risk has got to be in 2026, the Fed actually cut more than expected. I don't think fundamentally they should. I think that was the basis of my dollar bullishness in ‘25, is I've never thought the US economy was as weak as others did. But I worry the Fed next year will cut more aggressively in price. We only have two cuts in for next year. That's going to bring down that hedge ratio cost, that's going to lead to that dollar selling.

TG: It's not a stretch to sum up the macroeconomic catalysts this year with a few words. Liberation Day and its aftermath. That signal event in April has, so far at least, been the principal component that explains quite a lot of market variance. And where trend moves are concerned, the dollar and US stocks have gotten the lion's share of attention since then.

Both markets seem like they've moved on from that volatility moment, but where stocks have fully recovered and then some, the dollar hasn't. Stocks keep climbing and we're going to talk much, much more about that next week as to whether and how long that should continue. The dollar, well, let's just say it's not recovered, but nor has its trend decline continued. It's just kind of done nothing for six months.

So, this week, we talked to Lee Ferridge, our head of macro strategy for the Americas, about what to expect for the US currency and US rate markets over the coming months. This is all a jumping off point for a broader discussion of currency trends and central bank tendencies around the developed world.

LF: Yeah, mate.

TG: Look who it is.

LF: Look who's back from an extended vacation.

TG: Yeah, a week and a day, is that extended?

LF: Well, the day was extended, wasn't it?

TG: Yeah.

LF: That was gratuitous.

TG: Missed two sets of Monday calls, as opposed to just one.

LF: Yeah, see, that didn't escape attention.

TG: That wasn't by accident. So, I've been sitting in the sun for the last week, and I have basically had my phone on. And I went into vacation mode, knowing that the dollar was still the big consensus short out there. People were starting to think equities could do no wrong, and that still looks to be the case. But I want to get your take.

What do you think are the biggest consensus risks that people are talking to you about in rates and FX specifically?

LF: The big one is the one you mentioned, is the dollar short. As you know from our data, the biggest underweight since 2021. That's still the one that's out there. It hasn't changed. I think since you've been away sunning yourself, we have started to see the return of some dollar buying. So, flows are now positive for the first time since August, actually the strongest we've seen since January. If you dig into it, the buyers are all domestic US investors. We're not seeing foreigners buy the dollar yet. We're seeing domestics buy it, but not foreigners, which is interesting.

And then even more interesting is when you dig down the hedge ratio for foreigners, that's not going up. The foreigners who are selling the dollar are not hedgers. It's not a fundamental driver. It's more a sentiment thing. I think there's been five days since Liberation Day or the few days after Liberation Day where we've seen actual foreigners buying the dollar. That's just six months now. So that sentiment against the dollar is still strong, hence the positioning, hence the consensus risk that is out there.

TG: Does that make you worry for the dollar in the future? Because we talk a lot about the hedge ratio elements, and you alluded to them before, and that the increased hedging of dollar assets by foreign investors has happened a little bit, but not probably to near the extent that has been covered in the media, or we've talked about anecdotally or heard about anecdotally. It still really hasn't moved.

So we're going to get to the fundamentals of the US economy, which I know you always have good thoughts on, but that outlook for the dollar, which has really done nothing for six months, when you look at the DXY basket, does that still point to downside, assuming those guys do get involved at some stage?

LF: Yeah, I think it has to. The fact that we've got, you know, as I say, foreigners have got this big underweight in the dollar, but not foreign hedgers. That the hedge ratio is around 55 percent, which pretty much the lowest we've seen since 2015 has actually drifted higher this year, lower this year, sorry. If you think about the hedgers as fundamentally driven dollar sellers, i.e. it's a relative rate story, they haven't become involved, because relative rate argument hasn't really worked. It's starting to work now. But if we think about 2026, and if the Fed are going to be cutting when the others have done and when they've got ahead of it, that cost of hedging comes down. 

So potentially, you have a big source of dollar selling to come. When these guys raise their hedge ratios at 55 percent now, they're at 75 percent in 2020. That's a potential big shift.

So yeah, we look at short-term positioning or even longer-term positioning and think, okay, everyone's short. Actually, they're not. The speculative guys are short. The sort of sentiment-driven guys are short, but not those fundamental-driven guys.

TG: And you've been very bullish dollars for a little while, and this sounds to me like you're turning just a little bit longer-term bearish.

LF: For most (of) this year, I've been sort of bullish ‘25, negative ‘26.

TG: Yeah.

LF: You know, the bullish ‘25 was wrong in February, March, as you say. Since April, it's done nothing. The DXY is where it was at the end of April, so we've done nothing for six months. I think the dollar can rally into the end of the year. The fact that the dollar selling we're seeing now is so much sentiment-driven, not fundamentally driven, maybe a little bit longer. But I've always had this lingering, and it's really coalesced over the last few months, negative view for ‘26 and beyond. A lot of it played around the Fed chair, about Fed independence, about who's going to replace power, the make up for the Fed board. That's hardened up over the last few months.

When I then look at this stage, when I look at the foreign hedge ratio, I look at relative rates, I think, well, the risk has got to be in 2026 the Fed actually cut more than expected. I don't think fundamentally they should. I think that was the basis of my dollar bullishness in ‘25, is I've never thought the US economy was as weak as others did. And consensus growth has now come back. We're back at 1.8 for the year. We're at 2 percent at the start of the year. So it's come all the way back. The dollar hasn't, but it was always that the US economy was not fundamentally weak. And I still believe that. But I worry the Fed next year will cut more aggressively in price. We only have two cuts in for next year. They'll cut more aggressively in price. That's going to bring down that hedge ratio cost. That's going to lead to that dollar selling.

TG: Let's talk about those fundamentals, because it's interesting to me that you kind of shifted your view, where I haven't changed my view, as I think people listening to this will know, I've been bearish dollars for a little while. Maybe not from the from the get-go. It took some momentum, as often happens with my way of thinking about the world, for me to get really on a view. But I'm actually now looking at the data and thinking, kind of what you were saying a few months ago, like this is actually not that bad. I mean, the inflation data is still not reflective of strong tariff pass through, so the Fed can kind of get away with what they're doing in terms of easing policy. But the total consumption data, and yes, this is a bifurcated economy, where the very well off are doing very well, and those who aren't, aren't. But overall, the economy is holding up relatively well, and I'm just thinking about the inflation risks alone. We still have inflation at 3 percent.

In as much as Fed independence concerns might weigh on the dollar and on rates, does inflation provide a pushback at any point? Is the tariff story as well as part of that, is that fully priced now or is that fully embedded into inflation at this stage?

LF: Yeah, I mean, we're seeing growth, consensus growth move back up. The inflation pressure, you're right, you're not seeing full pass through yet. But I mean, I look at PriceStats, you look at some of the sectors, you've seen a big rise in some of the year-on-year rates in the sectors. I mean, household equipment and furnishings were at 2 percent year-on-year on the first of January, it's now 5.5 percent. Apparel was 0.2, it's now 3.3 percent. Food was 2.5 percent, now 4 percent. So, look, there's some pass-through coming through from these tariffs here. We're still running at 3 percent year-on-year, which is not 2 percent, but the Fed is looking through it.

Powell has made it clear, they can look through the tariff pressure because it's a one-off adjustment. And they're right, in theory they are, but then you've got to worry about the secondary effects. Those secondary effects come through the labor market. I actually think, if and when we start to get labor market data again, I think the rest of this year the data on the labor market is going to be better than the Fed expects, better than the market expects. And that's going to cause that reassessment.

So, look, I'm not convinced the Fed cut in December. They clearly will go tomorrow because in the absence of anything to stop them, that's the default path and there's no data to stop them. Assuming the government reopens, and we get some payrolls reports before the December meeting, which is looking a little bit more questionable.

But if we did, I fully expect those payrolls reports to actually be okay and to perhaps stop a cut in December. And this is the basis of my view that we can see the dollar bounce over the next few months, although they're negative in ‘26.

TG: What's the basis for the more positive take on the labor market? And do you also see wage pressures anywhere starting to build because we have these labor supply dynamics that are I think pretty well discussed and well covered?

LF: Well, I think the wage pressures don't need to build. You just need wages not to come down. I mean, and that's what's happening because as I said, inflation is at 3 percent. Services inflation is close to 4 percent, mainly driven by wages which are running at 3.7, 3.8 and have been basically since the spring. And that's why services inflation hasn't come down since the spring because payroll is averaging whatever it is, 35,000 over the last three or four months.

And yet the unemployment rate is still only 4.3 percent. Wages are still running at 3.8 percent year on year. Jobless claims are only at 230,000. So there's the labor supply dynamics there straight away. You remember this time last year? We were all talking about the Sahm rule. And they all get triggered.

TG: Yeah.

LF: And you know, they cut by 50 in September, we triggered the Sahm rule, et cetera. That quickly fizzled out. Now, it's actually looking at the seasonal pattern. So there shouldn't be one because it's seasonally adjusted. But if you look at the total payrolls for the year and split it into quarters, so it should be 25 percent each quarter because it's seasonally adjusted.

Actually, last year in Q3, 20 percent of the total payrolls for the year were added in Q3. 31 percent for the year were added in Q4. And if you look back at the average over the last eight years, Q3 averages 20 percent of the payrolls hirings for the year. Q4 averages 26 percent. Shouldn't be that way because if the seasonals are working, then it should be 25 percent every quarter. But Q3 is definitely the weakest quarter when it comes to payrolls hiring.

So, on that basis, and on the basis that labor supply is going to continue to be a challenge over the rest of the year, we saw a big rise in domestic labor supply over the last few months, and which has offset foreign supply. There might be various reasons for that. But actually looking back over the last 10 years, four of the weakest seven months of domestic labor supply come in the last four months of the year. So September, October, November, December. November, December, generally seen domestic labor supply decline. That data is not seasonally adjusted. So my point here is, in Q4, you most likely see an increase in demand for labor, but you see a continued drop in supply. And this is where the basis of the view that actually the labor market data in Q4, just like it did last year, will paint a very different picture from what we saw in Q3. And that is where I come back to, if we actually get the data, the Fed doesn’t go in December.

And that's where I come back to, you've got this sentiment driven selling, back and quickly reversed, already reversed for domestic US investors. That's where I get that dollar bounce before I sell it in ‘26. And thinking about that, selling it in ‘26, this is interesting to me, because I wanted to actually use this podcast to focus a little bit more on long-term trends in not just the dollar.

TG: We're going to talk about some other currencies in a moment as well. But for the dollar next year, you brought up the notion of Fed independence and maybe then easing a little bit more aggressively.

What does that look like in your scenario for a week or dollar next year?

LF: Well, the interesting thing is, when you look at the pricing for next year on rates, we have 40 basis points of cuts in for the first half of the year, and 20 basis points of cuts in for the second half of the year. Well, Powell goes in May. So, we're saying the Fed will cut more aggressively under Powell than they will whoever succeeds him. That's a little odd, given everything that we're talking about.

And this is sort of where, do we get the 40 basis points in the first half of the year? Maybe in June. But it could well be if I'm right in the labor market, you actually see the Fed stay on hold again, just like we saw this year. But then I would expect to get an acceleration of easing coming through once Powell is replaced. Look, we have basically 60 basis points for next year. I'd be surprised if we don't get 100 basis points of cuts next year. I'm not saying we should. I don't believe fundamentally we should. But I think that is the way the Fed will lean because, and don't forget in the second half of the year as well, what you'll get, whatever pass through from the tariffs there has been, will be dropping out.

So then you will get inflation numbers that are more benign. The economy overall should be fine, but you're going to get these benign inflation numbers. And if you are leaning towards the dovish, that will give you the room to act. And this is why, I think you see it, I see much more aggressive cutting in the second half of next year, relative to the 20 basis points of the price at the moment.

TG: I wanted to shift a little bit because we always spend a lot of time, and it's always well covered by you as well when it comes to the US and the dollar. But we don't talk often enough about other currencies. And particularly Japan is something we don't cover simply for the longest time because there wasn't really ever that much to cover.

And now it does seem like every client meeting I have, I get questions about what I think about Japan. Now of course, we have a new prime minister. And I was, I don't know why I was surprised. It says more about me than anything else. But dollar yen is back basically to its highs of the last few years. The yen crosses are as well.

And we have this trajectory for yen weakness where, for years, people have been trying to buy the yen on a valuation case as well as on underweight positioning in our data.

Does the trajectory you're talking about for the Fed counteract any of the weakening yen pressures that we're seeing and have dollar yen actually appreciably go lower? Who wins, I guess, in this Dove Off?

LF: Look, I'm not convinced about that Japan are in the Dove Off, quite honestly, or the BOJ anyway. And I know the narrative, it's an interesting narrative that's come out surrounding the new Prime Minister, that she wants, you know, fiscal looseness, she wants to spend, she wants to stimulate growth. And that means the BOJ won't hike? Because people are looking at the Abenomics Playbook and saying, well, look what happened to the Yen. There was a very different BOJ governor back then, and Kuroda, rather than Ueda. Kuroda, much more of a natural dove. But more importantly, they were fighting deflation then. Now you have real signs of inflation. Wage growth is real in Japan this time.

The demand for labor is primarily domestic based, it's services based. Whereas previously, they exported manufacturing jobs because of demographic issues. Now I see demand for labor being more domestic based, healthcare in particular. Japan has transitioned from this manufacturing based domestic economy to one that is largely services based now. So, I think labor demand is real, the demographics, the decline in the population is real.

That leads, in my mind, to realistic wage pressures that are persistent, rather than sort of the temporary ones we've seen previously. That leads to persistent inflation pressure, particularly if you're going to stimulate the economy through fiscal policy. And I think in Ueda, you have a central bank governor who will do the right thing. And the right thing is that Japan needs to start hiking rates. They've been very reluctant and slow to move. And I'm not saying they're going to go this week because I don't think they will, although, you know, it's not beyond the realms, but I don't think they will. But we've got 50 basis points in for the next year for the BOJ.

If there's a risk to that, to me, it's probably they do more rather than less, particularly if the new prime minister can get her fiscal policies passed. We sure won't get all of them through, but if she gets a number of them through, then I think you have to expect that Ueda is going to be on the hawkish side, and I don't believe he will be holding back because of pressure from the government.

If you take that along with my view on the Fed, then you could see quite a short narrowing of that rate differential between the US and Japan, and that should naturally lead to Yen strength, I think. So I've been very surprised that the Yen weakness at the outcome of the election, I think it's the wrong move. I think actually you will see Yen strength on the back of this.

TG: How far do you think that can go? Is this a trend move or is this just getting us back to kind of the lows in dollar Yen that we had earlier this year when we had the big period of dollar weakness?

LF: I think it has potentially been more of a trend shift. But we know we've all been desperate for dollar Yen to get back to some sort of fair value, which used to be 100. I don't think it's that anymore, but maybe it's 120. I don't necessarily think we get there next year, but I think this can be a trend move that starts as moving back towards those sorts of levels over the next year or two.

You know, have we seen the highs in dollar Yen? Yeah, I think we have. We got to 162 in the middle of last year. We were at 159 in January. I don't think we're going back there. Maybe we get next year below 140, maybe towards 135, and then we carry on that trend back towards some sort of realistic valuation for the Yen.

TG: Do we get US rates through Japanese rates in the front end at any point?

LF: That might be a stretch too far. Tell me who the new Fed Governor is, and the new Fed Chair is, and maybe, but right now that seems a stretch.

TG: But they may not be far apart if you think about it. I mean, if you think the BOJ is underpriced to get rates to 1 percent and the Fed is underpriced to get rates below 3 percent. They're not too far away.

LF: So, you could be one and a half Japan, two and a half for the Fed, or two for the Fed. They're not far away, are they? No.

TG: Are there any other central banks in the developed world that you think have the potential to hike? I mean, the ECB is a good example of a central bank that looks like they're done. Are they on the brink of a hiking cycle in the way that Japan is? I mean, you can say a lot of similar things. Inflation is not quite the problem in Europe that it is maybe still in Japan, but we are at the end of an easing cycle.

Do you throw Europe into this group of economies that might surprise hawkishly, especially relative to the Fed?

LF: I'd be surprised next year, if I'm honest. I don't see that the growth and activity data is really there. So, we're at neutral, that's two percent neutral. The market is priced for it to stay there. For most of next year, I wouldn't strongly disagree with that.

I don't see where the inflation pressure will come from. Look, the trade tariffs are going to continue to be a drag. I think the thing about trade tariffs, you mentioned them earlier. No one knows where we go from here in terms of, we saw the Canada thing the other day, we saw the China thing last couple of weeks ago. It can blow up anywhere, right? No one knows where that might come from. What I would say though is they're not going away. We're now at a point where the US, if you annualize the monthly run rate, it's about US$400 billion a month, annualized. I think the Trump administration want that money. The One Big Beautiful Bill was passed. I think the promise of this revenue from fiscal policy was part of the negotiating process there through Congress. He's not going to want to give that up. So, they're not going away.

So, if you think about going back to the ECB in Europe next year, it's going to continue to be a drag on the European economy. Europe is still fairly high tariffs with the US. We've got the ongoing fiscal concerns in France. The debt break in Germany was a big story, but how much is it playing through really? So I'm not saying a disastrous year for growth at all for Europe, but I just think Europe could be really boring next year in terms of growth around trend, maybe rates around trend. I just don't see it as a story next year. I mean, you cover it closer than I do. Do you hugely disagree with that?

TG: I think they actually will start to discuss potentially hiking rates towards the end of next year because what we're seeing from the domestic demand side of things, especially through the lens of PriceStats, is actually inflation pressure is picking up quite a bit. And that's for an economy that you would think, as you mentioned, with trade tariffs, the opposite might be happening. You might be seeing weaker domestic demand pressures, and you have a labor market that is still pretty close to full employment, if not at it.

I think you're right, there's probably nothing to talk about for six months, at least. But towards the end of next year, if you still have inflation hanging around to 2.5 percent and bottoming out here, the hawks are going to start to take notice of that. And I think some of them have already. And particularly given you still have modest easing priced in, just that flipping of the dynamic to not having an easing bias to rates anymore, but to having truly two-way risk.

They talk about them being very data dependent and thinking in both directions now. Nobody really believes that. But that's where I think the market's shift in focus could come, is truly making it a two-way risk and actually starting to price some potential for higher rates. But I think you're probably right, for the next six, eight months, it's just going to be on hold, wait to see what Trump does.

LF: They might start thinking about thinking about higher rates, yeah?

TG: Yeah, exactly. Yeah, take a page from the Powell Playbook. Or maybe he could go run the ECB once Lagarde moves on. We'll see.

LF: Yeah.

TG: Last but by no means least, other than in most rankings of growth and productivity, we have the UK. Speaking of an economy where inflation is slowing, but very much still above target, do we think we now have priced the fullness of Bank of England easy? We had inflation data in the last week that suggested that a December cut is now coming, another cut after that. But of course, inflation is far higher than it is anywhere else.

Is that about right for what the Bank of England can actually hope to achieve? And what does that mean for sterling?

LF: I don't think it's right. No. I mean, yes, we've got 17 basis points in for December, but we've only got 50 basis points in before next June. So that's eight months with two cuts. In the economy that, as you say, is not growing exactly robustly, where the unemployment rate is now the highest since 2021. You've seen net job decline over the last 12 months, and wage growth will naturally follow.

And as opposed to the one big, beautiful bill in the US, you've got another round of fiscal tightening coming your way in the next few weeks. How we can only expect the Bank of England to cut twice in the next eight months, to me, still seems unrealistic, but it's sort of once been twice shy, isn't it? Because the inflation just didn't come down. And so the Bank of England has been one of the slowest to act.

But I think it's almost going to be one of those that suddenly it happens and they go in a rush. That it's sort of nothing, nothing, nothing. Oh, 50 or go very aggressively because suddenly the inflation has collapsed, the wage growth has collapsed. You know, and now they've got to catch up.

I mean, I hate to use this phrase, but it is almost too late, Bailey. Yes, he's got a big cognizant on inflation and how sticky it is. But when you look at every economic sort of, you think about every economic theory with the slow economy rising unemployment, you should be able to look through the stickiness of inflation because it's going to come down because growth is slowing. So it's been the age-old issue in the UK with stubborn inflation, certainly in this cycle. But it's hard to believe that inflation can stay high when you're going to see again more fiscal tightening. And don't forget, some of this inflation is fiscally induced. It was the higher NI contributions that we saw in April. That's played a role in this, particularly on the wage inflation, it's more the benefit side.

I think we're still woefully under price for how much the Bank of England probably do need to cut. But I've thought (about) that for a while. But at some point, it's going to come in a rush. And I think looking at the latest labor market report, look at the latest inflation data, the signs of that crack are there. The cracks are starting to show more. So, before June next year, I do expect them to cut more than twice.

TG: Yes.

LF: What does that mean for Sterling? Well, I'm going to give you a preview of my year ahead trade now, which will presumably be written towards the end of November. Short Sterling Yen is going to be my year ahead trade. It puts it together very nicely with the themes we've just gone through.

TG: Exactly. Lee, it's been great to catch up. Always a pleasure to hear from you. And we look forward to reading that view when our year ahead piece comes out, which should be actually in five or six short weeks.

LF: We better get on that. Yeah, it's going to be late November, early December, so it's not far away.

TG: There we go. Well, thank you again. As always, my friend, we will chat with you soon.

LF: Thank you.

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.