Our medium term views

   Our key forecasts

   What we like right now

  The View

      The week that will be

  Today still sees the publication of national GDP and inflation prints. The main source of uncertainty for next week's EA aggregate is Germany's inflation print given a number of idiosyncratic issues that create considerable forecast uncertainty. A downside surprise should see the market reprice EUR front-end rates lower by opening the door to consecutive negative surprises vs ECB forecasts ahead of the March meeting. We stay long the EUR front-end. Yesterday evening brought reports of Trump potentially announcing his Fed chair pick in the morning; Polymarket odds for Warsh increased sharply to over 85%--we discuss this in Rates - US.

The main event of next week will be the US labor market report, as well as refunding. Our economists are looking for a steady 4.4% unemployment rate and a below consensus NFP print of 45k on the back of potential revisions to the birth death model and some residual seasonality. We do not expect coupon changes at the February refunding announcement, but risks of WAM tweaks have increased, also raising the risk to our steepening bias. We are long 20y on the fly to benefit from an increased focus on term premium (see Feb refunding preview, 27 January 2026 and Rates - US for more).

We do not expect any action from either the ECB or the BoE next week, but are looking for a hike from the RBA. For Australia, we continue to like fading terminal rate pricing via 6m2y receiver ladders. For the ECB we do not expect to see a change in language, given the lack of updated forecasts, though any comments on the FX move will be closely scrutinized. Finally, for the BoE we see a 7-2 vote, and keep our Feb-June SONIA flattener. The wage survey may force markets to price back in some of the cuts taken out post GDP and PMI.

We add a beta breakeven long in EUR rates given the inconsistency between market pricing of inflation (a persistent undershoot) and of the ECB (hikes) - see Inflation - EU and Inflation Strategist, 28 January 2026.

The week that was

The main news of the week was last Friday's reported rate checks on USDJPY by both the Fed and the BoJ (see Liquid Insight, 27 January 2026), as well as President Trump's declared comfort with the dollar's decline. Spill-over effects into rate markets have been limited ahead of FOMC this week and refunding and payrolls next week. The German government's growth revision (to the downside), along with Sec Bessent's strong dollar comments helped stabilize the USD on Wednesday.

The Fed held policy rates as expected, but with a small hawkish lean in the statement and press conference. Rates markets were broadly unchanged, given no action was expected today and two labour market reports are due before the next meeting. Equally, the BoC left markets broadly unchanged on the day (see Canada Watch, 28 January 2026). We continue to see value in CAD steepeners.

Finally, Australian inflation came in above the RBA's forecast affirming our economists expectation of a hike next week (see Australia Watch, 28 January 2026).

   Rates - US

•   We hold core views: receive belly nominal & reals, steeper 5s30s, long spreads.
• Any initial swap spread or financial condition tightening on Fed chair decision should be faded; FX impact on rates limited for now.

Fed Chair finale

US rates curve steepened on the week and overnight in response to headlines that the Trump administration is preparing for Warsh Fed Chair nomination. Initial market response suggests Warsh = steeper curve & tighter financial conditions. We recommend fading a reactionary response, especially any swap spread tightening as we discuss below.

Bigger picture: US rates are range bound, consistent with our macro base case (strong growth, sticky inflation, stable employment, slow Fed cuts = sideways rates). Market broadly = low vol, carry seeking. Focus this week was on FX; we offer thoughts below. Our bottom line: FX doesn't matter for rates, outside of large moves; our attention is on Fed chair & refunding. Lean long.

Our core rate views: duration = receive belly rates, position for lower 5Y real rates; curve = 5s30s steepeners, tactical long 20s on the 10s20s30s for refunding risk; funding = long June & 1y1y SOFR/FF with stable funding; spreads = long, especially at 2Y; vol = surface steepening, sell short dated vol (1y1y) buy medium term vol (1y10y).

Biggest picture: vol low, carry on. It is well, but not fully, priced. Follow, don't fight.

Warsh unlikely to reverse RMPs

As of writing Thursday evening, the market has moved to price Warsh as Fed Chair nominee given press reports. Initial response = steeper curve & cheaper long end which likely reflects combination of pricing out Rieder & pricing in Warsh. Medium-term implications for spreads, curve, and duration:

Spreads: Fade any initial spread tightening. The market perceived Rieder as more likely to use Fed balance sheet to bring longer term rates down vs Warsh. In our view, what matters most for spreads medium term is Fed's continued RMPs. We think it is unlikely that Warsh reverses Fed policy on RMPs and will need committee majority to do so.

Curve: Marginally steeper. We do not view Warsh as having materially different views on policy rates vs Rieder. Back-end selloff likely reflects repricing of Rieder / low rate vol / carry expressions.

Duration: Fade any belly selloff. We do not expect Warsh to be more hawkish on policy rates vs Rieder. Most important criteria for Fed nomination likely loyalty & commitment to lower policy rates & easy financial conditions.

With Fed Chair decision likely behind us, next big focus for understanding Fed reaction function will be productivity impact on dual mandate. Higher productivity should mean stronger growth, lower inflation, & employment disruption. Productivity does not obviously mean lower rates; next Chair will have to sell it.

Rates & FX: rate parity => not rate scary

Clients asked how FX moves impact US rates this week. Our answer: small moves = not much, big moves = cheaper USTs. Background: covered interest rate parity (CIRP) works. Rate differentials hold over time, especially in recent history (Exhibit 4). CIRP can deviate, but typically not for long. FX intervention = signal but mostly string push.

FX move Qs: (1) weaker USD = rate impact? (2) intervention = rate & funding impact? Our view: small moves don't matter; paradigms & regime shifts do. Funding = wash.

Weaker USD rate impact: history says that a weaker USD has limited impact on USTs. Official sector steps to weaken USD have not mattered outside of initial signal. In recent years, higher US 2Y = strong USD & vice versa. Our FX strategist baseline is for EUR/USD 1.22 at end '26 & 1.25 at end '27. Rates won't care about these size moves.

US rate risk = FX moves > our strategist base case. Sharp USD weakening & disorderly move can mean higher & cheaper USTs. This was clear around Liberation Day. Disorderly = DXY +/- 5% in 0-3m. Smaller DXY moves should not matter much for US rates.

Intervention & US funding: history says it doesn't matter much. In theory, overseas USD / UST selling & domestic FX buying should see upward pressure on funding rates. History provides limited evidence of a material UST repo funding & short spread impact (Exhibit 5). Intervention size & length matter. Recent Japan MoF interventions to make JPY stronger have been small (recent avg $40bn); US rates have not cared. If MoF intervention >$10b US rates & funding may care; such big intervention seems unlikely. NY Fed custodial UST holdings are higher on the week ending Wednesday evidencing no clear UST selling from foreign officials to fund intervention.

Overall: we do not think modest USD depreciation matters (i.e. <5%). Larger FX moves can have a bigger impact on UST demand & rates. For now, we expect small rate impact. A shift from Treasury to weaker USD policy would matter for rates, we are not there yet.

Jan FOMC recap: JP hold won't get sold

Jan FOMC was a non-event. The rates market took limited signal. Powell at Jan FOMC: "it is not anybody's base case right now that the next move will be a rate hike". If the Fed is unlikely to hike, it is difficult to expect a material increase in front end / belly US rates. We previously recommended receiving Jan FOMC OIS for US data softening risk. Fed hold means we lose. We hold position for option value that FF drops / unexpected shock.

Feb refunding: watching for back end cut signal

We expect UST to keep coupon auction sizes unchanged at the Feb refunding, consistent with forward guidance in Nov. We are watching for UST signal on potential long end auction size cuts. Risk has grown with reduced odds of Fed politization & other steps to force rates lower, i.e. GSE MBS buying. See Supply - US for more.

Bottom line: we hold core rate views. Any initial swap spread or financial condition tightening on Fed chair decision should be faded. Small USD depreciation will not matter much for US rates or funding. Large depreciation (>5%) can have bigger impact. Focus on Fed Chair & refunding.

  Rates - EU I

•   We expect the February ECB meeting to be uneventful with policy rates on hold.
  We maintain strong conviction the next move is far more likely to be down than up
• EURUSUD appreciation and increased uncertainty concerns support being received Mar26 ECB €str, which we prefer over steepeners given carry considerations

Paste and pause

The February ECB meeting is likely to be uneventful. The updated assessment should "reconfirm that inflation should stabilise at the 2% target in the medium term." That would pave the way for no change in policy rates and only fine-tuning of communication. They will reiterate that the ECB will follow a data-dependent and meeting-by-meeting approach. Uncertainty will be in focus, which can be perceived as marginally dovish.

The press conference is likely to focus on the exchange rate, energy and questions about the next move. We doubt we will get anything new. ECB President Lagarde was particularly cautious and balanced back in December, despite hawkish forecasts giving her the opportunity to be otherwise. We doubt she will deviate from that caution next week. If uncertainty was a key factor back then for Lagarde to remain prudent, it has only increased since.

As a reminder, we still expect the ECB to cut policy rates by 25bp in the March 2026 meeting. That should be the last cut of this easing cycle followed by a long hold that lasts throughout 2026 and 2027. But, as we argued in last week's Europe economic weekly, our conviction on that cut is running low given the data. However, our conviction is still strong that the ECB's next move is far more likely to be a cut than a hike.

It's all about uncertainty

At the time of writing, we are still waiting for 4Q GDP data and January inflation. It looks like GDP may broadly be in line with ECB forecasts while inflation could be lower, although less so than we thought a few weeks ago given some noise in the German data. Energy prices are higher than assumed in the ECB forecasts, but the currency is stronger. Putting it all together, this is mixed news that offers no clear path to deviate from what the ECB told us in December.

Hence, we would expect the statement to reconfirm the outlook and to reiterate that the ECB will follow a data-dependent and meeting-by-meeting approach. Additionally, uncertainty is up. Since uncertainty was a key driver of Lagarde's cautious approach in December, we would expect a repeat of that next week.

What about the currency?

The press conference is likely to be dominated by questions on the Euro and energy prices. We expect very little new information. While energy prices could imply stronger inflation near term, the currency suggests a weaker rate in the medium term. We are therefore likely to be told that the new forecasts in March will offer more information on how relevant these new developments are. In the case of the Euro, we are likely to get the standard response that the ECB does not target the exchange rate but it's part of the inputs for those forecasts. We should probably expect, once again, the emphasis to be on the prevailing level of uncertainty. While this could be perceived as dovish, it would only reiterate the message given in December. Uncertainty is also likely to be the key reason for not providing any kind of forward guidance.

Prefer outright receivers over steepeners

The last few weeks have seen a decline in supply/demand concerns, the return of trade and geopolitical uncertainty, alongside a broad cheapening of the USD. In the euro rate market, the net impact was arguably perceived as negative for the outlook / bullish rates: Since the December meeting, 1y €str rates declined by an average of 9bp across spot to 10y forwards (Exhibit 6). Even so, the market's first fully priced move is still a hike.

We expect ECB-related rate expressions to be driven by views on two opposing factors: 1) the central bank's hawkish stance, and 2) downside risks to the outlook, especially in the context of the ECB forecast profile already showing two years of inflation undershoot versus the target. Indeed, this inconsistency presents opportunities for "beta breakeven longs" (see Inflation - EU). In our view, there are two main narratives:

• ECB cuts rates again by 25bp and the market prices-in even higher medium-term rates on an improved growth outlook. This is consistent with our base case. The difficulty is to identify which data or series of events may push the ECB to meaningfully shift its stance and allow the market to price in that cut. A combination of downside surprises in coming inflation prints and further EURUSD weakness would at least be needed. All ECB speakers will then have to be monitor more carefully for evidence of a broad-based shift in the central bank's bias.
• This narrative would support the case for steepener expressions. But the negative carry in front-end steepeners can be a hurdle, especially as the market will likely need to wait for sufficiently weak data to materialise. Therefore we still prefer outright positions and remain received Mar26 ECB €str (current: 1.92%, target: 1.65%, stop: 1.95%). Risks to the trade are stronger-than-expected data.
• ECB maintains its hawkish stance, does not cut again, and the market reprices forward rates lower as the monetary policy stance ultimately proves too tight. This would benefit our 1y1y OTM receiver spread (current: 3bp, target: 20bp, stop: -10bp). Risk is a macro rebound.

  Rates - EU II

• EGB demand on FX-hedged basis to tighten EUR FX-Sofr until the pickups are reduced by Fed cuts.
• High JGB yields may not halt inflows from Japan (yet) and a 50-100bp pickup over UST may still be attractive.
• Japan has room to reduce its underweight of euro assets with appetite for Italy potentially.

EGBs may still be attractive to Japan

We keep a tightening bias on the EUR FX-Sofr basis. EGBs offer a positive FX-hedged pickup over UST when using FX swaps across the curve.

Our forecasts imply the positive FX-hedged pickup from EGBs will sustain broadly until the Fed delivers rate cuts that bring US policy rates close to euro policy rates. Our economists forecast the ECB to cut rates by 25bp in March, and the Fed to cut by 25bp in June and July. Our global rate profile implies the FX-hedged pickup from 10Y German government bond over UST will fall to c. 0bp by July. After which, we expect tightening pressures in the EUR FX-Sofr basis to be driven more by liquidity divergence, especially on tighter euro funding as the ECB continues quantitative tightening.

10y JGB yields are at their highest since 1999 with no clear message from the BoJ yet that it will support the JGB market (Japan Macro Watch, 23 January 2026). But this may not necessarily imply a sudden rotation by Japanese investors from overseas bonds to JGBs: 1) if JGBs are expected to sell off further near-term, and 2) FX hedging cost faced by Japanese investors fall if the BoJ hikes and the ECB/Fed cuts more.

To the extent Japanese investors do not fully withdraw from overseas bonds, their demand for EGBs may be supported by a sufficiently high FX hedged pickup over UST. Japan publishes its net purchases of German, French, Italian, and Dutch sovereign bonds: in 2025, Japanese investors made net purchases of these sovereign bonds when their respective 10y bond offered a 50-100bp FX-hedged pickup over UST.

Net purchase of Germany, France, Italy, and Dutch sovereign bonds by Japanese investors was c. EUR 10bn in Jan-Nov 2025, on track to making their first annual net purchase since 2020. Demand for EGBs may have been supported by diversification needs, given Japanese investors have been reducing the share of euro debt vs dollar debt in their portfolio investment asset holdings between 2020 to 2024.

Japanese investors' willingness to invest more in Italy may have been supported by its improving fundamentals. Japanese investors net bought Italian sovereign bonds over three consecutive months to November 2025, totalling c. EUR 3bn. But their holding of Italian sovereign bonds is still c. EUR 7bn below the recent peak, suggesting scope for more purchases and, in our view, is a source of structural demand (European Rates Watch, 9 January 2026). We expect 10y BTP-Bund of 50-90bp in 2026, which implies a c. 50-80bp FX-hedged pickup over 10y UST after the Fed delivers the cuts we expect.

 Rates - UK

•   June MPC-dated Sonia looks cheap, even accounting for upside risks to our eventual terminal rate forecast. Low coupon Gilt price action will be interesting.

 Bank of England decision in focus next week

The Gilt curve is ending the week marginally steeper, balancing sharper steepening in USTs against a 5y-led rally across the Bund curve (Exhibit 8). ASW moves were relatively muted, with the 5y sector standing out due to slightly more pronounced tightening.

Next week, the main risk event will be the Bank of England (BoE) Monetary Policy Committee (MPC) on Thursday. We outline our thoughts in an excerpt below. In terms of trades, we maintain our paid February 2026 MPC-dated Sonia against received June 2026 MPC-dated Sonia into next week, entered on 23 November in the Global Rates Year Ahead, at a spread of -24bp (current: -23.6bp), targeting -40bp and a stop at -17bp. Risk to the trade is a strong wage survey further reducing implied chance of a cut by June. We will need to address this trade next Thursday, with any dovish tilt in the MPC's stance having the potential to flatten the curve.

Aside from the BoE, Thursday's tender of UKT 1/8% 2028 saw a strong 3.77x bid‑cover ratio. The bond has been richening versus Sonia this week, trading as tight as -8bp in Z‑spread terms, with low‑coupon front‑end Gilts richening ahead of today's UKT 1/8% 2026 redemption. From a visual inspection of chart in a recent Bank of England blog, we estimate that retail owns around £16-17bn of the bond.

We continue to favour UKT 0.125% 2028 to express a tactical view that at least some of this retail cash will be re-deployed back into low coupon Gilts post-redemption. Among the popular low coupon Gilts, UKT 0.125% 2028 offers a higher post‑tax yield (Exhibit 2) and relative cheapness versus the UKT 0.375% 2026. We stay long in UKT 0.125% 2028 on ASW, monitoring on z-spread (currently -6bp). Entry: -2bp. Target: -20bp. Stop: 10bp. Risk to the trade is the DMO meeting demand with programmatic Gilt tender(s). For more, see UK Rates Alpha, 21 January 2026.

7-2 vote with risks of a 6-3

Our economists expect the Bank of England (BoE) to keep Bank Rate on hold at 3.75% at its meeting next week. The BoE's gradual guidance, the pickup in inflation, firmer sentiment data, and elevated price and wage expectations rule out a back‑to‑back cut, in their view. Meanwhile, although the labour market continues to soften, it is not weakening quickly enough to justify another immediate cut. In December, the BoE emphasised the need for greater caution as policy approaches neutral, with decisions on further easing becoming a closer call. We expect the decision to hold Bank Rate at 3.75% to be supported by a 7-2 majority. We expect Taylor and Dhingra to vote in favour of a 25bp cut, with a risk that Ramsden could also vote for a 25bp cut.

Flat hunting

Having traded largely within a 3.50 - 3.75% range since "Liberation Day" in April, GBP front‑end rates ended 2025 hovering around 3.50% (Exhibit 10). But the start of 2026 brought a notable shift in dynamic, with the eventual terminal Bank Rate pricing moving decisively higher. December GDP and the preliminary January PMI releases on 15 and 23 January, respectively, were particularly instrumental in driving this repricing (Exhibit 11).

In our economists' view, the data has been more mixed than the recent hawkish repricing suggests. We agree, with some of that move likely exacerbated by stops in the market. Our base‑case terminal rate remains 3.25%, but, as before, the risks are tilted to the upside. Next week's pay data will be important for our assessment.

Still, June MPC-dated Sonia (pricing in less than one 25bp Bank Rate cut) looks cheap, even accounting for upside risks to our eventual terminal rate forecast, we would argue (Exhibit 12). We will need to revisit our February/June MPC-dated Sonia flattening view after next Thursday's MPC meeting, with any dovish tilt in the MPC's stance relative to market pricing having the potential to flatten the curve. We continue to favour flatteners rather than outright receiving expressions given the trend drift higher in Sonia fixings (Exhibit 13) and a rebound in front-end directionality to the US rates this January.

 Rates - AU

•    Our economists expect the RBA to raise rates by 25bps to 3.85% on 3 Feb.
• We still like buying 6m2y receiver ladders because CPI data this week suggested rate hikes are likely to be unwound.

Inflation too high for the RBA to hold

We forecast the RBA will hike the cash rate target by 25bps to 3.85% on Feb 3 in line with consensus. Persistent inflationary pressure, a positive output gap with demand accelerating amid supply-side constraints, and a tight labour market suggest a more restrictive stance is necessary. RBA communications will stress data-dependence, but signal further hikes are possible if the current inflationary pressure continues.

Front-end curves are too steep

Even after yesterday's post-CPI rally, 2-3y rates are trading near the top of a 15-year range. The reason rates have historically receded from this level is that policy rates are unlikely to remain persistently above neutral rates for consecutive years. Our economists estimate neutral rates are around 3.5% and the RBA has deliberately hewed closer to this rate in its hiking and easing cycles (a strategy successive RBA Governors have described as pursuing a "narrow path").

No evidence that neutral rates have shifted meaningfully

In our view, this week's CPI was not high enough to suggest neutral rates have been misestimated, which is why rates rallied across the curve. Consequently, we continue to recommend 6m2y receiver ladders (buy 6m2y receiver ATM, sell 6m 2y receiver ATM - 18bps, sell 6m2y receiver ATM -36bps, current level -4.5bp).

Forecast revisions: higher near-term inflation, growth and lower unemployment

The SMP will release updated macroeconomic forecasts, conditioned on some technical assumptions. The assumed cash rate path is around 90bps higher than in November, while the TWI has appreciated by roughly 4%, both of which will put some downwards pressure on inflation, growth, and the labour market forecasts. Tighter financial conditions will mostly effect 2027 forecasts given the lags in transmission.

Trimmed mean inflation forecasts will likely peak around 3.5% in 2Q '26 and will not be expected to sustainably return to the target midpoint until at least mid-2027, reinforcing the need for a higher cash rate that the forecasts are conditioned on. A more dovish cash rate path than the market is pricing would push inflation forecasts further above the target and unemployment further below the NAIRU.

GDP growth will likely be revised up from 2.0% to around 2.3% in 4Q, primarily reflecting stronger household consumption. This will likely see GDP growing above the RBA's estimate of potential, leading to a slightly larger positive output gap.

The labour market should be assessed as tighter than full employment, and we expect the near-term unemployment rate forecast will be revised lower given the trend decline through 2H '25. The Dec '25 RBA minutes flagged some refinements to the RBA's assessment of conditions relative to full employment, which will be released in the Feb SMP.

Hawkish risks to the outlook

The three key risks to the RBA's forecasts outlined in the November SMP have all evolved in the hawkish direction, in our view.

• Demand growth looks to be overshooting estimates of potential supply. Household spending far exceeded consensus expectations in Oct (1.3% m/m vs 0.6% expected) and Nov (1.0% vs 0.6% expected), suggesting the RBA will revise up their consumption growth forecast for 4Q. Housing momentum remains firm and we expect prices to rise 6-8% in 2026, which should spillover to broader private demand and see near-term growth forecasts revised higher.
• Recent labour data suggests less spare capacity than the Nov RBA forecasts of a rise to 4.4% implies. Capacity utilization is above its long-run average (which we view as a timely proxy for the output gap) and continued to rise through 4Q, suggesting cost pressures will likely remain a challenge.
• Global growth has proved surprisingly resilient, with the global economy likely to grow 3.4% in 2025 despite elevated policy uncertainty. We expect resilient global growth will continue in 2026.

Small chance of a hold, but what could lead to it?

We see a strong chance of a hike next week, but the Board will likely consider two options: 1) 25bps hike, 2) hold at 3.6%. They may opt to hold rates if heightened global geopolitical uncertainty, questions around Fed independence, and renewed tariff threats, raises concerns about the external backdrop. That said, this consideration may carry less weight as last years' experience showed domestic growth remained resilient to overseas developments.

A dovish read of the CPI could also support a hold. As Deputy Governor Hauser said in an interview on January 8 "we are not targeting Q4 2025 inflation", and the Board could point to weaker housing inflation in December as supporting a 'wait and see' approach to confirming the persistence of inflationary pressures.

However, holding rates amid persistently above-target inflation with upside risks would raise questions about the RBA's commitment to the inflation target. A hike would be consistent with the RBA's hawkish shift in communication over recent months.

  Rates - JP

•    Domestic financials' unrealized losses on JGBs have been expanding, but the risk of forced, disorderly selling remains low
• However, some risks remain for banks and insurers, and we stay alert to spikes in JGB yields before the election.

Expanding JGB valuation losses

Driven by chronically weak demand, expectations of further BoJ rate hikes, and rising fiscal concerns, the 10-year JGB yield has climbed to a 27-year high. While higher yields support financial institutions' earnings, a rapid rise can worsen their finances by expanding valuation losses on their bond portfolios.

Disorderly selling is not likely, but some risks remain

We judge the likelihood that the recent increase in yields will trigger forced, disorderly JGB selling by financial institutions to be low. Current accounting rules for bond holdings make it unlikely that individual institutions would be forced into mandatory actions. That said, if valuation losses widen further or other risks materialize, some institutions could come under greater pressure to realize losses on JGBs.

Post-election timing to buy long-end

Overall, we see limited risk that Japanese banks or life insurers will be forced into disorderly bond sales in the near term. However, this does not eliminate the possibility of a sharp rise in long‑end yields. Until the election on 8 February, the long end of the curve remains vulnerable to sudden spikes in response to fiscal-policy-related headlines.

If investors are considering entering a flattener ahead of the 8 February election, the 2s10s JGB curve is likely the most suitable expression (see Q&A on increased intervention risk in USD/JPY, 27 January 2026). For 5s20s or 5s30s flatteners, entering around 10 or 12 February appears more appropriate. If the ruling coalition secures a majority in the Lower House, the FY2026 initial budget-approved by the cabinet in December-is expected to pass the Diet with minimal revisions.

Looking back at the October 2025 LDP presidential election-a period when fiscal concerns similarly intensified-after Takaichi won the leadership contest on 4 October 2025, effectively confirming her as the next prime minister, the curve twist‑steepened on 6 October, the first trading day after the vote. However, as markets became increasingly confident that a significant fiscal expansion would be avoided, steepening pressure eased on 7 October, and the curve subsequently flattened through the end of the month.

If the ruling parties win a majority in the upcoming Lower House election, the FY2026 initial budget is likely to pass largely unchanged from the cabinet-approved draft. As a result, fiscal-expansion concerns in the bond market would likely recede within two to three trading days after the election.

 Rates - CA

•         The BoC held its policy rate at 2.25%. CAD rates moved modestly lower, pricing out expectations of a BoC hike in 2H '26.

The BoC holds policy rate at 2.25%

On January 28, the Bank of Canada (BoC) held its policy rate at 2.25% (est. 2.25%, BofA 2.25%), in line with our expectations. This marks the second pause after cutting a cumulative 100bp in 2025. According to the BoC's statement, the outlook remains broadly the same and the economy is still adjusting to the structural headwinds of US protectionism and ongoing uncertainty, as well as the slowdown in population growth. The BoC says the current policy rate remains appropriate based on that outlook.

Canada faces heightened uncertainty

Once again uncertainty tied to US trade policy and Fed independence remains a key issue for the BoC, continuing to disrupt the Canadian economy. Governor Macklem stated during the press conference that USMCA talks pose an "obvious risk" and highlighted that a loss of Fed independence "would affect us all". Moreover, he underscored the impact of the current elevated geopolitical risks. Once again, Macklem stressed the limits to monetary policy but stated that it can play a supporting role for the economy. Lastly, the BoC emphasized that under the current outlook, "the range of possible outcomes is wider than usual", underscoring that they are aligned with the risks and will act if something crystalizes that changes the situation materially.

BoC: We expect the BoC to hold again in March

We still expect the BoC to hold the rate at 2.25% in the next months as it continues to assess incoming data to gauge the economy's direction. However, a negative output gap and a labor market with underlying weakness may lead to cuts, in our view. Moreover, core inflation decelerating gives the BoC room to cut. We anticipate an additional 50bp of cuts in 2026, likely split between April and June. Our call has upside and timing risks: a retightening of the labor market, a bigger-than-expected fiscal impulse from the 2025 Budget, a closing output gap and persisting trade uncertainty may lead the BoC to hold longer than we expect or even a hike.

CAD rates modestly lower, price out BoC hike

Canadian rates rose heading into the BoC announcement before quickly dropping 2bp lower at the front-end on the statement release. The BoC statement and press conference were perceived as balanced between both downside and upside risks, implying rates are likely to remain on hold. Market pricing of a BoC hike continues to get priced out, in line with our expectations. We continue to recommend clients fade pricing of BoC hikes. The CA 2s10s curve has been an attractive steepener position due to positive carry and rolldown, especially vs the US. We continue to believe the CA 2s10s curve can steepen in both a rate rally and a rate sell-off: (1) in a global re-acceleration BoC forwards can price more hikes, while US could have more resistance from inside and outside the Fed to price hikes and (2) in the global slowdown scenario, we think long CAD yields have less room to decline vs US given that it could be difficult for the CAD market to price a neutral rate materially below 0% real where the BoC currently sets policy.

   Front end - US

• Sharp USD weakening & disorderly move can mean higher & cheaper USTs via de-risking & UST selling.
• US funding impact = limited. Large scale UST selling could impact USD funding b/c increase in repo collateral.

Weaker USD has small impact on US funding

Clients have asked about USD depreciation impact on US funding. Our short answer: impact is small. A large USD depreciation or intervention is needed to move needle.

USD & rates: history suggests weak relationship

History says that a weaker USD has limited impact on USTs. Official sector steps to weaken USD have not mattered outside of initial signal. In recent years, higher US 2Y = strong USD & vice versa. Our FX strategist baseline is for EUR/USD 1.22 at end '26 & 1.25 at end '27. Rates likely won't care about these size FX moves.

US rate risk = FX moves > our strategist base case. Sharp USD weakening & disorderly move can mean higher & cheaper USTs. This was clear around Liberation Day. Disorderly = DXY +/- 5% in 0-3m. If disorderly FX move there could be de-risking & UST selling.

Large scale UST selling could impact USD funding b/c increase in repo collateral. History offers few examples, outside of March '20 COVID extreme. Even during Liberation Day USD weakening & UST cheapening, US funding was very stable (Exhibit 16). In theory, weaker USD & UST selling could impact funding. In practice it is rare.

Intervention & US funding: minimal impact

Client intervention Qs: (1) how does $ move? (2) funding & spread impact? We address.

Intervention fund flows: we consider 2 angles: (1) MoF funding source (2) plumbing.

MoF funding source: if Japanese MoF intervenes to sell USD & buy yen, it needs to fund its USD selling. MoF can fund via Fed foreign RRP or UST sales. We assume MoF would initially draw on foreign RRP & then replenish RRP via UST redemptions. On net, total USD reserves would be unchanged with more USTs held by private investors. Note: MoF reserves = $1.37t, securities = $1t (likely mostly USTs), cash = $160b (likely mostly RRP).

Intervention plumbing: there are 4 types of FX interventions, which are a function of (1) Treasury & Fed single or joint intervention (2) sterilized vs unsterilized. We assume any US yen intervention today would be joint Treasury & Fed + unsterilized (unsterilized b/c Fed already expanding balance sheet via RMPs). We show $ flows in Exhibit 17. A joint & unsterilized intervention would see larger Fed balance sheet, reduction of private sector JGBs, & increase in private sector USTs & reserves.

Funding & spread impact: history says interventions typically have a very limited impact on funding (Exhibit 18). We also see a relatively weak but generally intuitive relationship between size of intervention vs cash rates & swap spreads. TGA would temporarily decline to pay. Historical MoF intervention sizes are small (avg: $40b). Funding & spread impact could rise with size.

Bottom line: USD has historically small impact on rates, funding, & spreads. Impacts can be bigger if large & fast FX move. For more detail, see our FX intervention primer.

   Supply - US

• We expect UST to keep auction sizes unchanged at February refunding.
• Recommend UST stick with monthly 7y issues, continue with cash vs switch buybacks, and support SOFR FRNs.

Feb refunding: stable sizes, long end cut signal watch

We expect UST to maintain coupon auction sizes at the February refunding, consistent with forward guidance in November (see: Optimal focus & Exhibit 19). We are watching for any UST signal (via refunding statement or TBAC discussion) on potential long end auction size cuts. Risk has grown with challenges to force Fed cuts (i.e. Cook & SCOTUS skepticism, regional Fed appointments, etc.) & other steps to force rates lower, i.e. GSE MBS buying. UST could push rates lower by shifting issuance to front end.

Any signal of long-end cuts should drive UST knee-jerk bull flattening & widen long end asset swap spreads. We are long 10s20s30s fly for risk UST discusses or signals lower long-end auction sizes at the Feb refunding (see: Davos dependent). Such a strategy could challenge UST "regular and predictable" framework & add uncertainty to financing decisions. The administration may be less concerned with such a shift.

Bottom line: We expect UST to keep auction sizes unchanged at February refunding. We are long 20y on fly given increased risk that UST signals reduction in WAM & long-end auction sizes. We recommend UST stick with monthly 7y issues and think that while buybacks on yield spread would make entry easier, UST should continue with cash vs switch buybacks. We are also supportive of SOFR FRNs; we encourage UST to use only 1 FRN benchmark at a time (ex-transition period) & explore 1Y FRNs.

  Inflation - US

•  We are long 5y real yield & 10y BEI, anchored by dovish Fed reaction function & administration focus on affordability through lower borrowing costs.
• While in theory weaker dollar should be supportive of these views, flight out of USD assets could be a headwind.

Remain long 5y real yield & 10y BEI

Our above market forecast for inflation in 2H '26 (Exhibit 22) supports a preference for longs in real yield (RY) & breakeven inflation (BEI). We remain long 5y synthetic real yield (current 101bps, target 40bps) and 10y breakeven inflation (current 2.34, target 2.55). While shutdown dynamics & base effects will optically compress YoY inflation compensation from February through the end of August, it is important to account for these in pricing (see: Bumpy ride for YoY inflation).

Beyond data, Fed & administration policy decisions will be big drivers of real yield & inflation comp. A Fed that leans more heavily on downside labor risks vs above target inflation would support RY & BEI longs. An administration that takes steps to ease financial conditions & suppress borrowing costs support longs in RY & BEI as well.