Week 19

Macro

The FED held rates unchanged, in line with market expectations. What was unexpected was the lack of commitment to future cuts. The FED is ‘not in a hurry’ to cut but has warned about the growing risk of inflation and higher unemployment caused mostly by Trump’s tariffs. The FED failed to affirm any expectations, which means that it doesn’t know what is going to happen and does not attempt to guess. Despite the clear announcement of the FED’s direction and little change in the ‘totality of economic data,’ the FED is becoming more dovish, based on the Bloomberg Fed Sentiment Index, which quantifies the sentiment of Federal Reserve officials’ communications. This dovish posture should support a steepener trade, making the long end of the curve less attractive.

Macro data does not indicate any signs of slowing; however, a continuous dichotomy exists between soft and hard data. While hard data points to ongoing economic activity, soft data reflects growing pessimism among consumers and businesses. This divergence suggests that although the economy is currently stable, there is increasing concern about future conditions, which could potentially lead to reduced spending and investment:

  • Hard data:
    • Labour Market Resilience: The U.S. economy added 177,000 jobs in April, indicating continued strength in employment despite broader economic concerns.
    • Consumer Spending: Despite a slight contraction in GDP, consumer spending showed resilience, partly due to pre-emptive purchases ahead of anticipated tariff-induced price increases.
  • Soft data:
    • Consumer Confidence: The Conference Board’s Consumer Confidence Index fell to 86.0 in April, marking the fifth consecutive monthly decline and the lowest level since the onset of the COVID-19 pandemic.
    • Manufacturing Sentiment: The S&P Global U.S. Manufacturing PMI for April was revised down to 50.2, indicating stagnation in manufacturing activity.

All uncertainty leads to a decrease in investments. We observed a gentle rebound in investment at the end of last year, but now, capex in US manufacturing stands at its lowest level in the post-COVID era (measured by BEA’s standardised annual percentage change of real gross private non-residential fixed investment).

Tariff plans have raised recession concerns among strategists and economists for the first time since late 2022 and early 2023. However, the current economic data appears steadier than it did back then, and growth concerns are largely driven by perceived recession risks.

Tariffs could, in theory, generate revenue that supports fiscal relief or even stimulus. For example, redirecting tariff income toward tax cuts or targeted transfers might help cushion the economic impact of trade tensions. However, the effectiveness of such measures is constrained by the current fiscal reality. With the U.S. already running a historically large deficit, tariff revenues are likely only sufficient to maintain existing tax relief, not to introduce new, growth-stimulating policies. As a result, these efforts merely preserve the current economic dynamics rather than provide meaningful stimulus.

At a more tactical level, we are beginning to see the emergence of early trade agreements, with this week’s UK-US trade deal standing out. The US-UK trade accord and renewed optimism over China negotiations have fuelled a rally in risk assets and weighed on long-duration Treasuries.

While largely symbolic, it sets the stage for future announcements and signals a willingness to de-escalate tensions. However, the UK’s unique position, being one of the few major economies running a trade deficit with the US, means this agreement is not broadly representative. The deal includes UK-specific provisions that underscore the complexity of broader trade negotiations.

Key elements of the UK-US deal include:

  • Removal of tariffs on UK steel and aluminium exports
  • A 10% tariff reduction on the first 100,000 UK-made cars imported into the US
  • Tariff exemptions for Rolls-Royce aero engines and parts
  • A commitment for the UK to consult the US on significant Chinese investments, effectively giving Washington veto power

While the direct economic impact is minimal, the deal has had a positive effect on market sentiment. The administration maintains that a 10% across-the-board tariff on US imports would not be recessionary, and Friday’s market reaction to the UK-US announcement appears to validate this view. More broadly, this development raises optimism for progress in US-China negotiations.

prolonged US-China talks remain a major economic risk. Ironically, the recent market rebound may weaken the urgency for policymakers to act swiftly.

Despite the market’s positive reception of progress in trade negotiations, most economists still point to significant tariffs in place that will slow growth and are likely to put the US into recession.

Dollar Drift: Structural Overvaluation, Global Rebalancing, and Reserve Realignment

The U.S. dollar has declined significantly this year, yet it remains structurally overvalued based on the long-term average Purchasing Power Parity (PPP) of currencies within the DXY basket. If cross-currency PPP relationships hold, the dollar could depreciate by an additional 3–4% annually over the coming decade. Several factors are driving this potential long-term decline:

  • The new U.S. administration aims to narrow the current account deficit, which would reduce global demand for dollars. For decades, the U.S. has acted as a consumer and borrower of last resort, leading to persistent deficits and structural overvaluation of its currency.
  • Rising political instability in the U.S. is undermining confidence in the dollar’s status as the global reserve currency.
  • Foreign investors are reassessing their exposure to U.S. assets and plan to reduce it, prompting capital outflows.

The overarching theme is global trade rebalancing. If the U.S. successfully reduces its external deficits, demand for dollars and dollar-denominated assets will decline. Recent aggressive tariff announcements have shaken investor confidence and prompted a shift away from U.S. concentration risk. Although the dollar remains the de facto global reserve currency, held by nearly all central banks, recent capital inflows have been driven by private investors. Over the past five years, foreign retail and institutional investors have purchased nearly $9 trillion in U.S. equities, nearly doubling their ownership. Total foreign holdings of U.S. equities and bonds now stand at approximately $18 trillion and $15 trillion, respectively.

Meanwhile, gold has experienced a parabolic price surge in recent months, appearing overbought based on historical patterns despite a recent pullback. At current levels, other commodities like silver, platinum, and oil appear relatively undervalued. This price action reflects a broader trend: central banks around the world are diversifying away from U.S. Treasuries and the dollar, while increasing their gold reserves. A weaker dollar has also lifted Bitcoin, which has recently surged back above $100,000.

It’s worth highlighting the extreme moves in Asian currencies that show signs of repatriation, with money leaving the US and returning to APAC. The Taiwanese dollar saw a 4% drop, followed by a 5% drop in just two days. We also observed significant movements in the Korean Won, Thai Baht, and Malaysian Ringgit. Asian currencies appear set for further gains as easing US-China tensions improve risk sentiment and drive foreign inflows into regional equity markets. Emerging Asia (ex-China) has seen three straight weeks of net equity buying – the longest streak in over a year—reflecting growing investor confidence in earnings and supportive currency trends.

Rates

Despite lingering uncertainty at the central bank, the treasury market remains calm, with the MOVE index below the April 2nd level. We can see how the rates market has settled down, with the 10Y ending the week at 4.35%, roughly the same as two weeks ago when it was 4.31%. Just two weeks ago, the market was expecting 4 rate cuts this year; now it’s down to 2.7 expected by the year-end.

Rates have generally declined in April, with the curve becoming bull-steepened. The 2Y fell by 29 bps, while the 10Y decreased by 6 bps, resulting in a 23 bps increase in the 2Y/10Y slope, which now stands at 57 bps. The 2Y/10Y further flattened to 47 bps in May. This movement was primarily driven by an increase in recession risk following the tariff announcement and was exacerbated by the ‘sell America’ trade.

The front end is pricing in 109 bps of rate cuts in the next 12 months. Over the last two years, the bond market has consistently overestimated rate cuts, and even today, the Fed expects only two cuts this year. The market may be mistaken again, and the yield curve will flatten if the US economy remains resilient and inflation proves stickier. However, with the anticipated economic slowdown, the yield curve is likely to steepen. In the event of a recession, short-term yields will indeed have further room to fall.

Market inflation expectations have risen in May, with the 10Y TIPS breakeven inflation rate increasing to 2.29%, after declining from 2.38% to 2.23% in April. Going forward, we expect to see further steepening, with the longer end moving up significantly due to inflation data. Additionally, the rates market and the dollar will become even more important indicators for the economy.

Credit

Spreads have tightened since the tariff announcement on the ‘liberation day’ (02/04/2025), but remain wider than last year. The average IG bond spread is now 99 bps, after widening 12 bps over last month. This is nearly 20% up from 80 bps at the end of last year. Investors might see another 15-20 bps widening if the unemployment rate increases to 4.8% and PMI dives further. Cyclical sectors offer additional spreads but remain most exposed to anticipated economic weakness and should be avoided by those who assign a high probability to recession risk. US IG Corporates are dragging Treasuries by -144 bps this year, with 62 bps lost in April.

The average HY spread is also 20% higher at 342 bps compared to 287 bps at the end of last year. Similar to IG, the HY is heavily exposed to a potential increase in the unemployment rate. Based on the historical relationship, if unemployment increases to 4.8% while PMI falls further, we can anticipate an 80-100 bps widening in HY spreads.

On a relative basis, US municipal bonds experienced a significant decline. Munis underperformed Treasuries by 194 basis points in April, resulting in year-to-date excess returns of -565 basis points pre-tax. This has led to improved valuations, with muni spreads to duration-matched Treasuries at -20 basis points—well above recent norms, and tax-adjusted spreads compared to corporates near post-pandemic highs. For the heavily taxed US investor, munis present relatively attractive opportunities at the current valuations.

There is a significant amount of liquidity in the credit market. Over the past few years, the market has not expanded, with most activity centred on refinancing and few new issuances. At the same time, we observed an increase in the assets under management of credit managers and an expansion of private credit. This results in a scenario of excessive demand and insufficient assets. The best example is the high-yield leveraged finance market, where net supply has barely been positive this year. All of this exerts downward pressure on credit spreads, which are now decreasing after experiencing peak tariff uncertainty, with IG and HY spreads around 100 and 240 bps, respectively. With an impending economic slowdown and a high risk of inflation, those spreads may widen.

Equities

The current equity rally continues to gain traction, supported by improving macro sentiment, better-than-expected jobs data, and easing trade tensions—especially following the limited but symbolic US-UK trade deal. This optimistic tone has driven down realized volatility, enabling systematic strategies such as vol control and risk parity funds to increase equity exposure. Volatility has also declined due to the initial trade agreements and the confirmation of the Fed’s independence. Trump stated he has no intention of removing Powell before his term ends in less than a year, and the Fed has signaled it will not yield to political pressure.

Despite this, markets remain jittery, reacting quickly to headlines, particularly regarding US-China relations on low volumes. Nevertheless, US equity investors maintain optimism, with the S&P 500 recovering its losses and now trading at 20.4 times forward earnings, suggesting markets are pricing in a favorable outcome. However, the path to avoiding a recession remains narrow.

The VIX has collapsed, and the S&P 500 has returned to pre-‘Liberation Day’ levels. However, the relative value proposition has deteriorated, as the US is now in a weaker economic position compared to before. While the initial fear has subsided, the tariff situation remains unresolved, and progress has been slow.

The options market reflects a growing risk appetite, with increased long-dated call positions. However, hedging behavior around the 5,500 to 5,600 zone on the S&P 500 indicates a divergence between institutional and retail positioning. The rally, initially led by retail and 0DTE flows, is now supported by both mechanical and discretionary flows. Still, with forward earnings guidance under pressure and valuations stretched, the market remains vulnerable. The rally may continue in the short term, but it is largely based on hopes of favorable trade outcomes and fiscal stimulus, which may prove unsustainable. A correction remains a real risk.

Optimism surrounding potential tariff de-escalation has also driven a strong rally in European cyclical stocks, with autos, energy, and banks leading the Stoxx 600 this week. These gains were supported by earnings beats, sector-specific tailwinds—such as BMW’s upbeat guidance and rebounding oil prices—and hopes for fiscal stimulus, particularly in Germany. As a result, cyclicals have outperformed defensives by the widest margin since 2008. However, long-term risks persist, with 2025 earnings forecasts still being revised down due to persistent tariff and currency pressures.

Buybacks have contributed to market support, reaching $234 billion in April, the second-highest amount on record (behind April 2022’s $242.7 billion). Most major corporations reported earnings that exceeded expectations and highlighted their balance sheet strength. They continue to retire shares, with buybacks totalling $500 billion over the past three months. This suggests that if volatility increases, companies may step in to support their stock prices.

Equities could move sharply higher next week if US-China talks result in meaningful tariff relief. Even symbolic concessions may be enough to lift stocks, crypto, the dollar, and Treasury yields. Many investors continue to believe that the ultimate impact of tariffs will be manageable and short-lived. However, even a reduction in China levies to below 60% would still leave US effective import tariffs at multi-decade highs, causing lasting damage to corporate earnings and global trust.

Finally, despite recent gains, technical indicators suggest caution. The market is forming a rising wedge and a bearish cup-and-handle pattern, both typically associated with downside risk. This week’s upcoming data, including CPI, PPI, and import/export prices, will offer insight into the early effects of tariffs and could influence market direction.