Macro Musings:
- Though the US consumer is far less sensitive to oil today, the energy shock is expected to offset much of the OBBBA benefits, with higher gas prices negating the spending boost from larger tax refunds. Recent lows in the personal savings rate and declining consumer sentiment suggest little capacity for the consumer to absorb higher energy costs. The war in Iran presents a significant headwind to growth in an economy already running solely on AI optimism/infrastructure and upper-income spending.
- The labor market seems relatively balanced on the surface, with supply falling in tandem with demand, but it is increasingly fragile with little to no jobs growth outside of healthcare, and with declining labor force participation that is creating an optical illusion of a “better” and “stable” unemployment rate. The “no hire, no fire” environment illustrates the stagnant nature of the labor market, but rising layoffs in white collar/office industries (amidst layoff announcements) suggests accelerating weakness.
- Though the war in Iran and higher oil prices are having a potent effect on headline inflation, longer-term inflation expectations remain anchored and the passthrough into core prices is expected to be mild. We view global demand destruction (as a result of the war) to eventually spillover and flow into the US economy as a primary risk factor, where growth should slow more significantly, limiting pricing power and inflation risks.
Market Thoughts:
- It’s one thing when risk markets climb the wall of worry, it’s another to be in denial of the reality still to come. In our view, broader markets have overshot again and are at risk of serious disappointment the longer the Strait of Hormuz remains closed. Therefore, as we start another month (after a monster rally in risk on hope and earnings extrapolation euphoria), there is a risk that the pendulum swings back if there is renewed geopolitical chaos.
- Macro products are still grounded in fundamentals, so the longer the Strait of Hormuz stays closed (or worse if the US/Iran war reignites), higher oil is almost a near certainty given the lack of throughput and available float. This will drag up US rates again, the question is for how long. Recall the 2yr initially lagged and then overshot the rise in oil in mid-March, as position squaring and global rates pulled up US rates too. This time, if oil continues to rise, we think US rates will start to decouple on growth fears.
- We argue that low vol is now more a reflection of less conviction (and thus can be misleading as a result) versus confidence of a good outcome in the Middle East. Fixed income dislocations have been slower to cure but many relationships have mean-reverted, even in rates space. However, if rates are going to be trading at higher levels for the foreseeable future (and at a risk of another oil shock) higher vol may return too. Therefore, we turn tactically neutral MBS spreads and would fade longer-end belly butterflies.
Fed and Rates View:
- Powell’s last FOMC meeting and developments in the Iran War have moved markets and our view incrementally less dovish. At the latest FOMC, rates remained unchanged and the Fed kept the “additional” qualifier in the statement (which denotes an easing bias). This outcome revealed heightened divisions within the Fed, as dissenters favored removing the dovish bias. Overall, this will make it more difficult for Warsh to convince the board of early rate cuts and reduces the likelihood that the Fed will cut soon.
- Yet, we are firmly of the view the Fed remains mildly restrictive and that is having an adverse effect on small-to-midsized firms, housing and other interest rate sensitive sectors. The longer rates stay above neutral, the more impact it will have on the job market. However, the economy now faces its fourth supply shock this decade, and as a result we expect the Fed to be more cautious before acting. We are also in a Fed leadership transition period, where incoming Fed chair Warsh will likely set the stage to pivot the FOMC towards cuts (at the Jackson Hole symposium).
- Unless markets hit an out of the blue air-pocket and suffer an acute tightening and/or inflation effects fade quickly, it’s challenging to see imminent cuts at this point. Therefore, we expect two cuts later in the year (September and December). Our base-case is that once the Strait of Hormuz reopens, and oil moves into $75-100 range, the current headwinds and lack of growth catalyst leaves a path open for 2 rate cuts later in 2026.
US Policy Updates:
- The Senate Banking Committee voted to approve Kevin Warsh as the next Fed Chairman, teeing up a Senate vote that allows him to take the position on May 15 (and be ready for June FOMC).
Special Topic – Foreign Flow Forensics: Past versus Present Activity:
- We did a deep-dive into historical country-level holdings of US assets (government bonds, agencies, corporates and equities) dating back to the 1980s to analyze trends in foreign demand.
- We appended historical TIC estimation data from a Federal Reserve paper by Bertaut-Tyron with recent TIC data to re-create our best-efforts estimate of foreign holdings data of US assets, accounting for changes in transactions and asset valuations.
- Takeaway: US assets are becoming increasingly concentrated in the hands of private investors vs the official sector (which hasn’t been accumulating for years). These flows are linked to countries with large developed financial centers that are predominantly domiciled in Europe and the Caribbean, suggesting true foreign ownership is lower if assets are held by leveraged investors like US hedge funds. Meanwhile, there are signs of countries seeking to diversify their holdings given rising US fiscal deficits. As the end user investor base shifts, expect higher volatility and rising debt financing costs over the medium term for US debt issuers.
Please see the PDF report link above for the full write-up with charts and forecasts…