Macro
One-time tariffs are expected to be a transitory shock, similar to the supply chain disruptions experienced during the COVID pandemic. However, the pandemic taught us that supply shocks can have far more persistent effects than initially anticipated by economists, sometimes lasting years. The Federal Reserve is now cautiously assessing whether tariffs will generate such lasting disruptions. If not, and if the tariff-driven supply shock proves to be short-lived, much of the uncertainty could dissipate.
The weakest point for the U.S. lies in the potential for reciprocal tariffs or regulatory actions targeting its most dominant global export – digital services. While several European countries have already implemented digital services taxes, they have done so on a national (not EU-wide) basis and without applying them retroactively. Canada’s recent proposal to apply such a tax retroactively (potentially raising $2 billion) marks an escalation that could set a precedent for broader international moves. Because the U.S. is home to most of the world’s major technology companies, these measures disproportionately impact American firms and risk becoming a serious source of diplomatic friction.
Should the U.S. retaliate, or if other countries follow suit, the resulting trade conflict will target one of America’s most valuable and globally integrated industries. Given that digital services are a key driver of U.S. service-sector exports and a source of its trade surplus, any multilateral backlash could undermine U.S. competitiveness and trigger broader geopolitical and market consequences.
Alternative inflation measures that tend to lead CPI, such as Truflation and PriceStats, show prices up 1% this month, raising concerns that inflation could jump in the June and July PCE reports. The labour market is not loose enough to absorb this potential inflationary spike. While the President and Treasury Secretary are eager to reduce interest costs, any rate cuts must be justified by economic data; otherwise, markets are likely to reject them. Indeed, we should recall how markets pushed back against the September rate cut, driving long-end yields up by 100 basis points.
The Fed officials made it clear this week that it will take a few more months to gain confidence that tariffs have not triggered an inflation surge. For now, they remain on hold. Encouragingly, May’s core PCE rose only 0.1% MoM, which is the smallest increase since the pandemic began five years ago.
Consumer spending is losing momentum. Recent data show only a modest rise in May, with a notable slowdown in services outlays. As excess savings dwindle and credit conditions tighten, households are starting to pull back. This raises concerns about the sustainability of consumer-driven growth in the second half of the year.
Despite stable and low unemployment and inflation hovering around 2.5%, the Fed is cautious. Tariffs, geopolitical tensions, oil prices, productivity shifts, and broader political instability continue to cloud the outlook. While these uncertainties persist, the Fed’s decision-making will remain firmly anchored to incoming data.
The future trajectory of rates will depend on how markets interpret the Fed’s actions. If a cut is seen as appropriate and justified by economic weakness, markets are likely to respond constructively. But if it appears politically driven, the consequences could be destabilising. Trump has long expressed a desire to remove Jerome Powell, and his criticism has intensified over the past two months due to the Fed’s decision to keep rates elevated. On Wednesday, Trump called Powell a “very bad option,” though he didn’t name a successor.
Powell’s term ends in May 2026, but Trump may nominate a replacement well in advance. This raises the risk of Powell becoming a ‘lame duck’ chairman, with his messaging potentially overshadowed by a dovish successor. Markets are highly sensitive to any perceived erosion of Federal Reserve independence. Most economists warn that political interference, especially from the White House, could undermine the Fed’s inflation-fighting credibility, leading to increased volatility, higher bond yields, and a weaker dollar. Following Trump’s remarks this week, U.S. Treasuries rallied, and the dollar weakened.
On the political fringe, some argue that the President, as the democratically elected leader, should have greater control over monetary policy. While the President does appoint the Fed Chair, they should not interfere in the Fed’s decisions, especially between terms, as doing so could set a dangerous precedent that undermines the institution’s independence and destabilises markets. Empirical evidence from other countries is clear: where central bank independence is lacking, inflation is higher, currencies are unstable, and economic growth is slower. Any political interference would be a mistake, both in theory and based on empirical evidence from other countries.
The notion of a “shadow Fed Chair” has emerged, with Powell increasingly perceived as guarding the Fed’s independence, even at the cost of adopting a more hawkish stance than he might otherwise prefer. Nonetheless, rate cuts are likely needed as signs of economic weakening build, and the global 2% inflation target is being increasingly challenged in a world where supply-side flexibility is diminished.
The “Big Beautiful Bill” is currently making its way through Congress. While its main critique is that it doesn’t go far enough in nominal terms to address the fiscal deficit, Scott Bessent notes that it includes the largest cut to non-discretionary spending in U.S. history. However, the focus has shifted: the administration’s objective is no longer to cut spending aggressively but to stabilise it while boosting growth. With peacetime spending running at 6.7% of GDP, the administration aims to stabilise debt-to-GDP levels and bend the curve downward through economic expansion, rather than affecting nominal outlays through fiscal austerity.
In the Middle East, Iran attempted to launch missiles back at the U.S., but the attack failed—Qatar intercepted the missiles, resulting in no damage or casualties. The market interpreted this as a sign of Iran’s limited military capabilities. Consequently, oil prices fell sharply, and stock prices, along with other risk assets, shot up.
Investors are now awaiting key U.S. economic data on Thursday, including jobless claims, durable goods orders, home sales, and the final Q1 GDP reading. These will provide crucial insight into near-term economic momentum. It’s also a holiday-shortened week, with U.S. markets closing early on Thursday (1 PM) and remaining closed on Friday for the July 4th holiday. Trading desks are expected to be lightly staffed, and volumes will likely be thin.
Rates
Continued tensions in the middle east as well as this weeks dovish comments from the FED’s offials movtivated bets on lower rates. Furthermore, weak consumer confidence readings from Tuesday pushed 10Y yields below 4.3%.
This week, we saw increased option volume in a bet that 10Y will decline to the lowest level since April. The bulk of it came on Monday and Friday, following Trump’s announcement of a ceasefire. In total, $38 million in option premiums were added to positions anticipating a 30 basis point drop in the 10-year yield from the current 4.3% to 4.0% by August. If realised, this would mark a sharp reversal from the May peak of 4.6% and bring yields back to levels last seen after Trump’s “Liberation Day” speech on April 2.
Treasury options markets are now skewed toward calls, indicating rising demand to hedge against a bond rally. While short-end call skew has persisted for some time, this is the first time since April 2025 that long-end skew has decisively shifted toward calls. In parallel, asset managers have resumed building net long duration positions in Treasury futures, increasing net longs by $14.5 million this week.
Labour market dynamics continue to drive rate expectations. The last time the unemployment rate held at 4.2%, it coincided with a contraction in the labour force of 625,000 workers. Continued increases in continuing claims suggest that unemployment may soon rise, potentially leading to a more pronounced steepening of the yield curve. Notably, the 20Y–2Y curve has already moved from -100 bps to +50 bps over the current cycle.
Political developments are further shaping rate expectations. Trump hinted this week that he would appoint a Fed Chair committed to aggressive rate cuts. Markets have responded by repricing the Fed’s terminal rate closer to 3%. While expectations for the terminal rate have swung widely over the past 18 months, the 3% level remained a floor throughout this adjustment process.
Equities
U.S. equities ended the week on a strong note, with the S&P 500 and Nasdaq closing at fresh record highs set back in February, extending a sharp rebound from their early-year lows. Dow up 3.8%, the S&P 500 up 3.4%, and the Nasdaq gained 4.3% this week. This rally occurred despite hotter-than-expected inflation data, underscoring investor optimism fueled by easing trade tensions and upbeat corporate earnings.
Overall, Q2 was particularly strong, with the S&P 500 posting a V-shaped recovery and rising 11.6%, its best quarterly performance since Q4 2023. Resilient U.S. economic data, receding fears of a trade war, and upbeat earnings all helped push the S&P 500 to 6,215 by the end of June, bringing its year-to-date gain to 7.5%. In June alone, the S&P rose 5.1%, while the equal-weighted index gained 3.4%, primarily led by Technology and Communication Services.
This narrow leadership is expected to continue as the Magnificent Seven begin reporting earnings in late July. The group rose 7.7% in June and nearly 20% in Q2. Style-wise, Growth (+6.2%) and Cyclicals (+5.8%) extended their outperformance for a third consecutive month, while Defensives trailed with just a 2% gain. Growth outpaced Value by 2.5%, and Cyclicals beat Defensives by 3.8%, with no signs of mean reversion. Small Caps staged a modest rebound but remain negative year-to-date.
Still, not all signals point upward. Some strategists are flagging potential headwinds later this year as the impact of policy changes begins to be felt throughout the economy. While prices challenge all-time highs, volume has been notably lower, especially in futures. Volatility remains subdued and near the lower end of its historical range. The options market reflects this complacency, and implied volatility is near cycle lows. The key concern for investors now is growth. If growth slows, earnings momentum could fade and disappoint.
The key concern for investors now is growth. If growth slows, earnings momentum could fade and disappoint. Analysts now expect the slowest pace of earnings growth in two years. Q1 imports surged 40%, while the U.S. represents just 25% of global GDP, suggesting a significant pull-forward in demand. The market might still see a good Q2 earnings season due to FX impact of the international revenues as 40% of S&P 500 comanies revenues are from itnerneatinoal market. The Dollar Index was at 110 last year, then it averaged 107 in Q1, and now it is averaging 100 in Q2.
The S&P 500 currently trades at 22x forward earnings, about 35% above its long-term average and near cycle highs. According to Bank of America, the index screens as “expensive” across all 20 valuation metrics it tracks. To return to fair value, S&P 500 companies would need to deliver 30% earnings growth—an ambitious hurdle. A rate cut would also help justify these valuations.
Nevertheless, the sentiment remains firmly risk-on. High-beta strategies are strongly outperforming low-volatility ones, on track for the best relative quarter since 2020 (based on performance of Invesco’s S&P 500 Low Volatility vs. High Beta ETFs). Mega-cap tech continues to lead, with Nvidia standing out in recent days, now trading above its upper Bollinger Band and above 70 on the RSI, both signals of overbought conditions. With such strong momentum, the rally is expected to continue.
A few things work in the market’s favour:
- Q2 earnings season might still surprise to the upside, especially given FX tailwinds. Around 40% of the S&P 500 revenues come from international markets. The Dollar Index was at 110 last year, averaged 107 in Q1, and is now closer to 100 in Q2—a meaningful shift that supports foreign earnings translation.
- Tariff deals are still being negotiated. Rate cuts are now expected. A shift toward a more dovish Fed Chair is also possible.
- Investors remain underinvested, with over $7 trillion parked in money market funds. Despite elevated valuations, this creates conditions for performance chasing. FOMO is back, and price sensitivity is low.
From the FANG era to today’s Magnificent Seven, a handful of mega-cap tech companies have led markets for over two decades. Now, we’re transitioning from the SaaS era into the AI era—and this shift will bring major structural changes. AI is poised to disrupt nearly every industry. The U.S. labour market alone—worth around $20 trillion annually—faces massive transformation. Free Cash Flow for the Mag-7 is expected to decline as the company ramps up investments in AI infrastructure. While investors are often hesitant when companies bet on emerging technologies, such as CapEx, it is a necessary investment to support long-term growth. A similar story played out during the early cloud era, when companies like Amazon and Google invested roughly 10% of their cash flow into cloud businesses that now generate nearly half their profits.