Weekly market commentary

Stuck in place
Change in U.S. 10-year yields from the start of Fed rate cut cycles since 1984

Mega forces like AI driving markets and the macro while the Fed still has cover to keep cutting interest rates are keeping us pro-risk. We think today’s macro environment still supports our view that lower inflation and a softer labor market allow it to do so. Renewed concerns over Fed independence after the investigation of Fed Chair Jerome Powell may challenge that view. Yet we see immutable economic laws, such as the need to finance U.S. debt, serving as a guardrail. U.S. 10-year Treasury yields haven’t dropped as they have historically when the Fed cuts rates – and are still higher since rate cuts started. See the chart. That reflects investors demanding more compensation for the risk of holding long-term U.S. bonds, or term premium, due to worries over fiscal sustainability and debt servicing costs even before the latest Fed independence concerns.

Sticky inflation may limit how much the Fed can cut rates this year beyond what markets forecast. The December data confirmed that the U.S. labor market is still in the “no hiring, no firing” stasis we’ve previously described and doesn’t look at risk of a sudden deterioration. Yet wage gains and core services inflation point to risks that inflation stays above the Fed’s 2% target. We see the potential for renewed policy tensions between inflation and debt sustainability that could spark investors demanding more term premium. But we think immutable economic laws are still at play and could curb policy changes: that any rapid rise in long-term yields would quickly impact debt sustainability.

Powerful mega forces can trump the macro

Developments like policy uncertainty or fiscal concerns mainly transmit through the cost of capital channel by lifting risk premia, in our view. We see that transmitting clearly today in U.S. Treasuries: concerns over the U.S. fiscal outlook and worries over Fed independence that began last year have pushed the term premium higher over the past 18 months. The same mechanism shows up in equities via the equity risk premium – our preferred valuation metric that accounts for the interest rate environment. The return on capital channel – profitability and a firm’s ability to return cash – can also drive relative performance but typically only after more durable shifts. What matters for our positioning is whether a development has a meaningful, lasting impact on these channels and markets broadly. We would lean against moves where we don’t see a sustained impact, such as short-term market reactions to geopolitical events that ultimately prove contained.

This all reinforces why this environment calls for a nimble approach and plan B for portfolios based on scenarios when many potential outcomes are possible. We stay pro-risk as we think the AI theme has more room to run – even as geopolitical fragmentation and potential diminishing trust in institutions could lead to a reevaluation of global risk premia.

Our bottom line

Fed independence worries reinforce our underweight to long-term Treasuries. We stay pro risk on mega forces like AI and a macro backdrop that should allow the Fed to keep cutting rates – and prefer equities over government bonds.

Market backdrop

The S&P 500 was little changed overall at the start of fourth-quarter earnings season, with tech stocks lagging to start the year. Even with all the headlines of potential U.S. policy changes, markets have been relatively muted. U.S. Treasury yields have been in a range of 4.10-4.20% since the start of December. Yet Japanese ultra-long bond yields have kept hitting all-time highs on expectations for looser fiscal policy as the prime minister is expected to call a new election.

On a quieter data week, we are looking at what global flash PMIs say about global activity. Otherwise, the focus is on Japan where the expected snap election may pave the way for the ruling Liberal Democratic Party to pursue looser fiscal policy and add more pressure to global long-term bond yields. We are also looking to see if at-target euro area inflation keeps the European central bank on hold.

Read our past weekly commentaries here.