Macro Strategy

Crossroads and Headwinds

 

• Hawkish Fed signals, rising Treasury term premia, and geopolitical risks continue to build headwinds and elevate market volatility.
• Leadership transition accompanies BI's policy pause, but external headwinds continue limiting room for policy easing.
• Peak rate policy would reduce uncertainty, but insufficient to guarantee sustained market uptrend.

 

More Hawkish Fed Narratives. Markets remain at a crossroads, reflecting growing divergence between the Fed, financial markets, and households, which could lead to higher market volatility. At the same time, President Trump's latest tariff package, the renewed escalation in the Middle East, and rising concerns over Houthi disruptions in the Red Sea have added fresh sources of risk, contributing to higher Treasury term premia. Although markets still broadly expect the Fed to leave rates unchanged in July, elevated Treasury yields and a stronger DXY have already tightened global financial conditions, continuing to pressure the rupiah and Indonesian government bond yields. Key observations include:

 

The latest Fed Beige Book showed that the U.S. economy continued to expand at a slight to moderate pace, while overall price pressures remained moderate, supported by lower fuel prices in June. However, inflation expectations remain divided. Some contacts expect inflation to stay near current levels, while others anticipate a gradual easing, partly reflecting lower energy costs.

Recent Fed communication, however, has become increasingly hawkish. Dallas Fed President Logan called for higher interest rates, while Governor Waller and Cleveland Fed President Hammack indicated that another rate hike could be warranted. In his latest testimony, Chair Warsh reiterated that the Committee has no tolerance for persistently elevated inflation and remains fully committed to restoring price stability.

The 5Y5Y Forward Inflation Expectation Rate (T5YIFR) has remained relatively contained in the low 2% range, although it has recently begun to edge higher. Meanwhile, the New York Fed's June Survey shows households becoming increasingly concerned about short- and medium-term inflation, while long term expectations remain broadly stable.

Over the past week, the U.S. 10Y Treasury yield briefly reached 4.70%, its highest level since January 2025. While most of the increase was driven by higher TIPS real yields rather than rising inflation compensation, Treasury term premia have also begun to rise, reflecting renewed geopolitical tensions and trade tariff risks. This adds to the risk of further upward pressure on the U.S. yield curve going forward.

 

Bank Indonesia: Leadership Transition. This morning, Bank Indonesia (BI) announced the resignation of Governor Perry Warjiyo, who has led the central bank since 2018. Destry Damayanti, BI's Senior Deputy Governor, will serve as Acting Governor on an interim basis until a permanent appointment is made. In last week meeting, Bank Indonesia (BI) kept the BI Rate unchanged at 5.75%, following a cumulative 100 bps rate hike during May and June. Rather than relying on further rate hikes, BI has shifted toward a broader set of monetary tools, including targeted liquidity and foreign exchange measures, to safeguard financial stability and support the rupiah. In our view, this suggests that the policy rate has likely reached its peak in the current tightening cycle.

 

While peak rates provide some relief to financial markets, they are unlikely to trigger a sustained rally without a clear path toward policy easing. At this stage, such a catalyst remains absent. Higher U.S. Treasury yields, expectations of further Fed tightening, a stronger DXY, and El Niño related inflation risks are likely to keep BI cautious, limiting the scope for near term easing and maintaining a restrictive policy stance.

Some of the key points from last week’s BI meetings are:

 

1. Of the three conditions we monitor as potential triggers for further tightening, the recent stabilization of the rupiah appears to have been the key factor behind BI's decision to pause. At the same time, domestic economic indicators have moderated following the post-holiday strength in 1Q26 (Exhibit 8), providing additional support for maintaining the current policy stance.
2. Rather than relying solely on higher interest rates, BI is increasingly enhancing the attractiveness of rupiah assets while ensuring banks retain sufficient funding to support lending. Measures to encourage foreign portfolio inflows include higher FX swap incentives, new incentives for DNDF transactions and local currency settlement, lower hedging costs, and progressively tighter limits on foreign exchange transactions without underlying economic activities. Together with more active FX intervention and twice weekly SRBI auctions, these measures are intended to strengthen demand for rupiah assets and support exchange rate stability.
3. At the same time, BI has expanded liquidity support to ensure tighter monetary conditions do not constrain credit growth. The Macroprudential Liquidity Incentive ceiling was raised from 5.5% to 6.0% of third-party funds (DPK), while a new Money Market Deepening incentive of up to 2.0% of DPK was introduced to encourage greater interbank market activity. Broader flexibility under the Macroprudential Intermediation Ratio, a higher Foreign Funding Ratio, the reopening of longer tenor repo facilities, and wider collateral eligibility collectively reduce funding constraints, preserve banking liquidity, and support continued credit expansion despite higher interest rates.

 

Supportive, But Not Sufficient. Historical experience suggests that reaching the peak of the policy rate removes an important source of uncertainty and often marks the beginning of a more stable market environment. However, a policy pause alone has rarely been sufficient to trigger an immediate appreciation of the rupiah. As such, to ensure the more positive outcome, we expect the next Bank Indonesia governor to introduce a more clearly defined policy framework, particularly on managing the trade-off between maintaining financial stability and supporting sustainable economic growth.

 

Following the 2018 tightening cycle, the rupiah remained broadly unchanged during the first week before appreciating 2.6% after one month, 2.8% after two months, and around 2.0% after three months. A similar pattern emerged after the 2022–2023 tightening cycle, with the rupiah initially weakening by 0.9% before recovering by around 3.0% over the following two to three months as global market sentiment improved. Although the 2024 episode involved only a one-off precautionary rate hike, the pattern was broadly similar, with the rupiah initially weakening before ending around 1.9% stronger after three months.

 

These episodes suggest that while peak rates reduce the risk of further monetary tightening and provide a more supportive backdrop for financial markets, they do not guarantee sustained rupiah appreciation or a durable market uptrend. Such an outcome ultimately depends on broader external conditions, including UST yields, risk sentiment, and capital flows. Although BI's current policy mix should strengthen confidence by enhancing the attractiveness of Rupiah assets and preserving domestic liquidity, the limited room for policy easing means targeted liquidity measures and interventions are likely to remain BI's primary tools for maintaining stability while supporting economic growth.

 

… Read More 20260727 Macro Strategy