Executive Summary

This episode of "Rate Check" discusses the recent resurgence of geopolitical tensions in the Middle East, leading to a spike in oil prices and renewed inflation fears. This has fueled a hawkish repricing in global bond markets, with both US and German yields hitting multi-year highs. The podcast features insights from Francis Yared (Global Head of Rates Research) on the ECB's policy outlook and the long-term drivers of higher equilibrium rates, and Mallika Sachdeva (Global Head of FX Thematics) on the potential "structural reset" in Japan's fiscal and industrial policy, its implications for the JGB market, and the changing dynamics of the US dollar's funding.

Cleaned & Structured Transcript

Introduction and Market Overview

[00:00:02] [Unidentified Speaker]: Rate Check, where macro meets markets, a podcast from Deutsche Bank Research.

[Unidentified Speaker]: Hello and welcome to Rate Check, a podcast from Deutsche Bank Research.

Shreyas Gopal: I'm Shreyas Gopal, FX strategist, and I'm joined as always by my co-host and macro strategist, Henry Allen. Hello, Henry.

Henry Allen: Hi, Shreyas.

Shreyas Gopal: Busy times in markets once again with oil on the march higher, some softness in tech stocks, but a lot of different things going on. Why don't you walk us through some of the key themes and what clients have been asking over the past couple of weeks?

Henry Allen: So the big thing that we've seen change is the major escalation in the Middle East where the US and Iran have resumed strikes on each other, and the Strait of Hormuz that had shown signs of reopening is now functionally shut again. So we've seen a big increase in oil prices, currently at time of recording around $99 a barrel for Brent again. And markets now actually pricing in a 38% chance that the Fed might even hike at next week's meeting. So we've seen a big shift in market pricing. And with those inflation fears mounting, unsurprisingly perhaps, sovereign bond yields in several countries are at multi-year highs this morning. So actually this morning, the German 10-year bond yield hit 3.2% for the first time since 2011, and currently the 10-year Treasury yield is around its highest level since early 2025. So with rates generating a lot of headlines, it's very appropriate that today we're joined, among others, by our Global Head of Rates Research, Francis Yared. Hello, Francis.

Francis Yared: Hi, thank you for having me.

European Central Bank (ECB) Policy Outlook

[00:01:34] Henry Allen: So we're recording this with the ECB widely expected to keep rates on hold today, but markets and DB are predicting that they're then going to hike rates again in September. You've suggested the ECB isn't repeating the mistake it made in 2011. What underpins that view in your mind?

Francis Yared: Sure. So there is clearly some parallel between what's happening today and 2011 in the sense that you had the ECB tightening policy seemingly in reaction to a negative supply shock. Almost by definition, a central bank that tightened in reaction to a negative supply shock would feel, let's say, uncomfortable and like a policy mistake. But there are actually significant differences between where we are today and where we were in 2011 on several fronts.

[00:02:30] First, if you think about the private sector, in 2011 we're coming out of the Financial Crisis with several housing bubbles and therefore a need for households to delever. Today there is, in Europe at least, they haven't even used up all the excess savings accumulated during COVID. Second, you had significant intra-European divergence in 2011. If you look at actually the progress made, especially in terms of the improvement of the external position of the weaker countries, you have had since a significant convergence and therefore less fragilities within Europe.

Shreyas Gopal: So by that you mean the likes of Italy, France, Spain, all running deficits that are more convergent, closer together than they were in 2011?

Francis Yared: Not France, actually. France being actually the weakest link, but France being the only nuclear power within the eurozone, you can give them some geopolitical premium in a favorable sense for having that. But probably the most important point, though, is the outlook for fiscal policy. Right after the policy tightening in 2011, the pressure from the Eurozone crisis led to a significant fiscal tightening, not only in the periphery, but even Germany was running fiscal surpluses by 2015, 2016. Today we're looking at actually a completely different picture in particular from Germany, which our economy is now expecting them to have 4% to 4.5% deficits for the next four to five years. And these numbers have been, if anything, revised up over the past few months. So it's a completely different environment. And actually the view on the shift in fiscal policy and the excess savings is the reason why in our initial forecast for this year, we had a bond yield of 3.10% that was underpinned by a view that the ECB would need to hike to 2.5% by 2028. So what happened with the Iran war is that it mostly pushed forward those hikes, but without actually, in our book at least, adding anything extra beyond what we expected to happen in the next two to three years.

US Rates and Equilibrium Rate Outlook

[00:05:04] Shreyas Gopal: So hikes being brought forward in Europe versus where we were at the start of the year. Part of a bit of a global theme, of course, with the US having hawkishly repriced to the point that Henry made where we're now pricing in a non-negligible chance of a hike next week. And that's in spite of, on the surface, some softer US data over the past couple of weeks on the CPI front. So the two-year yield in the US at a fresh year-to-date high, that was also part of your thesis at the start of the year that the market was overly concerned perhaps about the labor market and the biggest mispricing or one of the biggest mispricings was in the US front end. In your mind, are we closer to fair value there now, and what does that mean for where 10-year yields go from here?

Francis Yared: Yes, so we, relative to where we are now, it's much closer to our initial assumptions. The rationale, let me maybe re-outline what was behind the view. So the rationale really rested on the fact that if you look at what drove the decline in equilibrium rate post-GFC, it was primarily a shift in the supply and demand of savings because ultimately interest rates is the price of money and therefore impacted by the supply and demand of savings. And again, I'm not going to go through all of them. We covered that ground, I think, last time. But if you look at every single factor that led to lower equilibrium rates, each one of them is actually going in the other direction. I've already mentioned fiscal policy, so maybe I'll just highlight another element, which is AI-related CapEx, which are in contrast to the fact that you needed back then in 2008, 2009 to see significant deleveraging of the private sector because of the housing bubble. So the bottom line is when we look at various estimates, which are obviously extremely uncertain, but most of the decline we saw post-GFC, you can make the case that most of that should actually be, should be back not exactly where we were pre-GFC, but not too far from that. And so that's the reason why we had actually a neutral growth up to 4%, which is more or less what the market is pricing today. In terms of the 10-year forecast, we actually raised our forecast from 4.45% to 4.8%. One of the reasons is because we were relatively conservative initially on where neutral was, and we've been able to adjust that. And the rest of the repricing from here is meant to come from term premia in our framework. That's a process which tends to be relatively slow, and locally has seasonals against it. But fundamentally, it's roughly the same driver as the logic for neutral, which is if you think about the supply and demand of bonds, that's also shifting significantly relative to what we saw post-GFC. And that's where the adjustment is coming from.

Japan's Structural Reset and JGB Market

[00:08:12] Henry Allen: So in terms of that topic of significant shifts post the GFC, that's perhaps a great time to bring in Mallika, our Global Head of FX Thematics, who also covers the Japanese yen. It feels obviously Japan has seen some significant shifts. There's increasing this narrative change in Japanese policy. Mallika, you recently wrote an extra report looking at what a strong and rich Japan could mean, looking at the shifts in fiscal and industrial policy. Would you be able to elaborate on that, some of the key themes that you think are worth highlighting?

Mallika Sachdeva: Sure, Henry, it's good to be on Rate Check. So I do think Japan could be at the precipice of a very significant shift in industrial and fiscal policy. And I always like to look back at history. And I think what's happening now has the echoes of the Meiji Restoration, which took place in the mid-19th century. So if we go all the way back to 1868, when pre-modern Japan was looking at the threat of foreign involvement. Opium wars had taken place in China. Japan had signed unequal trade treaties with Western powers. And they had to respond to this growing threat. And the way they responded, I think, is very telling because they consolidated power and pursued extremely rapid industrialization. And one could argue that Japan is facing similar sort of existential threats today with what's happening around globalization, insecurity with energy, the need to kind of rebuild defense, respond to AI. And Japan's answer is similar under Prime Minister Takeichi, who's consolidated power and is trying to return the country to what are its industrial roots. So this week, Japan passed the Honebuto, or the government's new basic policy on economic and fiscal management. And it's all about returning the economy to an investment-driven path, investing in AI and quantum and aviation and shipbuilding and critical minerals. And this is key for growth because I think mistakenly when people think about Japan and they think about the decline in potential growth that has happened there, everyone thinks it's about demographics. But the reality is it's about the collapse in capital investment. And that is what this government is trying to change.

[00:10:26] Now, Japan is not alone in the things it's trying to do. But where it is a bit lonely is in where it sits on the debt pecking order. So debt to GDP levels are quite high, around about 200% of GDP. So what Japan is going to have to do is find a way of creating fiscal space for these big industrial ambitions. And in the Honobuta this week, I think there are two big shifts that I would point to as interesting. One, that they're changing the fiscal target. They're moving away from targeting the primary balance to basically saying what we want to target is bringing total debt to GDP down in the long run. That will have implications for how they manage policy. And the second shift that they've made is to say, we want to create an asset management nation where they essentially wanted to sort of mobilize the domestic savings of the Japanese economy to try and fund these investments and keep financing costs down.

Shreyas Gopal: Those are pretty big shifts considering how we usually think about Japan or the cliche that's evolved about being quite slow moving, but there seems to be quite a lot happening all at once if you look at how the focus has shifted perhaps away from the yen to the 3% level on 10-year JGBs. Francis, your team has also written some excellent research on the JGB markets. And despite this, despite Japan flagging high in terms of debt to GDP, your team actually thinks that there's value in playing for a flattening of the Japanese curve and that actually what's more likely to happen is that those long end yields will be brought down over time. Be great to elaborate a little bit more on the value you see there.

Francis Yared: [00:11:56] Let me cover some of the most fundamental arguments. And it's effectively that sovereign risk is better explained by the external position than by the fiscal position. We've written a few articles to demonstrate the predictive ability of NIIP in terms of being a good leading indicator for bond returns.

Henry Allen: So that's the net international investment position.

Francis Yared: Yes, thank you. It's also actually clear if you go and look back at the various International Monetary Fund (IMF) lending programs that have been made over the past 30, 40 years, that the biggest difference between countries that go into a program and the average for the world is actually on the external position rather than on the fiscal position. So we've published a few number on the median program countries relative to the world average. And really the difference is pretty striking in terms of the weakness of the external position with the fiscal position, which is actually pretty close to the average. So how does that apply to Japan? Japan has a very strong external position. And so from that perspective, I think the sovereign risk is relatively low. And the solution in some sense to what Mallika was describing is effectively for the government to access private sector savings. And that can typically be done via taxes, regulation, etc., which is presumably what should be happening. The difficulty really when thinking about Japan is that it's a very technical market with relatively low liquidity. And so, having the timing wrong can be costly, to say the least. But it looks like, and that's where my colleagues in Japan have written a few notes on that. It looks like we're getting to the point where we're more likely to converge to what seems to be the logical outcome, which is a combination of faster Bank of Japan (BOJ) rate hikes and incentives for the private sector to invest domestically in equities, but in bond markets as well.

Henry Allen: Sure. So if the government are accessing private sector savings, Mallika, does that have implications for the Japanese yen?

Mallika Sachdeva: [00:14:22] Yeah, and I think I very much sort of echo Francis's sentiment that there will be this kind of increased policy desire to mobilize the savings of Japan, a lot of which are held outside, so to kind of tap Japan's external position. If the government, like we think, is now a lot more focused on yield management, and they've done a lot of what they could do in terms of the supply side, in terms of reducing long-end issuance, then really what they need to do is find buyers for JGBs and create that demand. And so then if we think about where is Japanese capital stuck and where is it held, I would argue it's held in two places, one in cash and two abroad. So to Francis's point, Japan has 5 trillion in portfolio investments held outside the country across pension fund balance sheets, insurance balance sheets. And intuitively, if in their Honobuto, they want to spend more on industry, on defense, on energy, then it makes sense that the capital to do that also comes back. So I think the two big sectors to focus on are the pension fund and households. And to put some numbers around this, the government pension fund has about 1.8 trillion in assets. Half of that money is held outside the country. And there is talk that they could be encouraged to bring some of that home. At the moment, they have a target of 25% of their portfolio to be invested in domestic equities and domestic bonds each. There is some flexibility around that. If Government Pension Investment Fund (GPIF) was to use the existing flexibility and go to the very top of the range, that alone could bring about 200 billion back into Japan. If there was an actual shift in the targets themselves, there was an actual policy asset mix review, then the numbers could be a lot greater. So I think if GPIF is tapped to bring money back, then that could be very FX relevant. I think on the household side, there's talk that the government will do things to encourage households to shift from cash and deposits and invest more in JGBs. That's less likely to have an FX impact because this is more just domestic money. But it could be very powerful for the bond market. So again, the Japanese households have 15 trillion in savings. Half of that's in cash. These are huge numbers. So even getting a proportion of that to move into the JGB market could be very powerful for rates.

Risks to Forecasts and US Dollar Funding

[00:16:56] Henry Allen: Okay, so to wrap up that segment, what do both of you think the biggest risk to your view are then, starting with Mallika?

Mallika Sachdeva: [00:17:03] Yeah, so I think our view on Japan from a market's perspective is that there does seem to be a shift away from FX management to a more concentrated focus on yield management. So all year we've been in this regime where Japanese policymakers have been solving for keeping the currency very stable. We've had verbal intervention, we've had rate checks, we've had actual intervention, and they've actually been very successful in keeping dollar-yen fairly close to 160 in the midst of wars, in the midst of all kinds of Fed volatility. I suppose our thesis now is that fiscal capacity is the key criteria, and to ensure that, they need to keep yields manageable. And so if Japan is going to do whatever it takes to keep yields down, then the question is what does it mean for FX? In a world where GPIF is bringing a lot of money back, and like our economists believe the BOJ is accelerating rate hikes, that is a world where the yen could strengthen back. The other way of managing yields, however, if all else fails, is potentially to tap the BOJ to resume Quantitative Easing (QE) purchases or to do some kind of Yield Curve Control (YCC) closer to 3%. And that could be very, very different in terms of the yen and could open up a tail for a weaker move.

Henry Allen: Francis.

Francis Yared: [00:18:11] Yeah, so the core view we've had for the past six months to a year and expressed in the outlook was that equilibrium rates and term premia were likely to go up on the back of the shift in the supply and demand of savings. And marginally speaking, the significant latent demand on fiscal policy amongst others in Europe. But given the repricing in rates at the moment, we're actually much closer to our initial assumptions. And so from a trading perspective, these are not today very, very strong view. The strongest trading view today is actually the flattener in Japan. While the timing is tricky, but relative to fundamentals, that's what the most misprice. But to answer your question, if you come back to what would be today the risk to our initial view of higher equilibrium rates, I'd say at the moment it's probably going to be a reassessment of US AI CapEx. For Europe, if anything, I think that's a source of upside because there is significant skepticism that Europe will do anything in tech. And it's as essential in my mind as achieving strategic autonomy in defense. And so I can only see upside there. While in the US, you can imagine a situation where the profitability of those CapEx could be reassessed at some point. And to me, that is at the moment probably the number one risk to the higher equilibrium rates view. That would come from a reassessment of the return on investment on all these AI CapEx.

Shreyas Gopal: And Mallika, that would be relevant as well for the dollar. One of the other pieces you've been busy writing this week is around the funding of the US deficit and how that's moved away slightly from bonds towards riskier assets and equities. Walk us through, if we outline the risks from Francis's view, how that might spill over to the dollar.

Mallika Sachdeva: [00:20:16] Yeah, absolutely sure. So there has been a big rotation in the way that the US funds its external deficit. If we look back through history, a lot of the foreign funding for the US was coming into Treasuries. Foreign official sector, foreign private sector was buying US bonds and that was funding the deficit. Over the last sort of 12 to 18 months, there's been a big shift where foreign demand for Treasuries has been declining, but foreign interest in US equities has surged to levels we've never seen before. About $750 billion came into US equities in the year to March 2026. And technology, AI returns, a lot of that is driving it. And so on one hand, the US is sort of replacing some lost Treasury dollars with equity dollars. But on the other hand, the profile of the US dollar could start to become a lot riskier. Because while in the past, in equity corrections and in downturns, when you had counter-cyclical demand for Treasury supporting the dollar, that may not occur this time. If anything, in the next equity correction, particularly if, like Francis said, there's an element of reassessing the AI trade in that, you could actually see outflows from the US in the midst of that. And that's a world in which the dollar is not providing diversification for a risk portfolio. And so the discussions we were having, say, this time last year around hedge ratios and do we want to keep unhedged exposure to the dollar could come right back.

Shreyas Gopal: Yeah, fascinating. I also definitely recommend Lachlan Dillon from Sydney's piece recently on those various correlations between the dollar and risk assets. Thank you both very much for your time. It's been a pleasure to have you both back on Rate Check. So thank you to Francis.

Francis Yared: Thank you for having me.

Shreyas Gopal: And thank you to Mallika.

Mallika Sachdeva: Great to be here.

Upcoming Events and Outlook

[00:21:57] Shreyas Gopal: And before I let you go, Henry, what else should we be looking for in the coming weeks ahead?

Henry Allen: Sure. So it's a very, very busy week, actually, next week before many of us go on our summer break. So we've got the Federal Reserve, of course, with speculation mounting about a potential rate hike. We've got another Bank of Japan meeting, lots of earnings as that season really ramps up, including some of the big tech names. And of course, all eyes will be on the geopolitical risk coming from the Middle East and any risks of escalation there. And of course, it goes without saying that in several late summer periods around early August, we have seen in recent years a few unexpected crises. It was only a couple of years ago that we had again trade block that took us all by surprise very suddenly after some unexpectedly weak US data. So we know that some with often quite thin liquidity is often a time when you see jittery markets. So it's certainly going to be interesting to see if anything happens.

Disclaimer

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Disclaimer

This transcript has been generated using artificial intelligence and may contain minor inaccuracies or omissions. For complete accuracy and context, please refer to the original podcast recording here.