Nothing Stops this Train

19 January 2025

It is only three weeks into the year, and it has already been an eventful one for the world and markets. Investor sentiment on equities has reached a near record bullish extreme according to Bank of America’s Bull & Bear Indicator (9.3 out of 10). Cash allocations in mutual funds have also fallen to a record low of 3.3% (a sell-signal). By contrast, investor sentiment has turned bearish on US Treasuries (higher yields, lower bond prices) driven by shifting views about the path of short-term interest rates and renewed US economic optimism. From our vantage point, while some activity and liquidity driven indicators suggest renewed positive momentum, this contrasts with non-trivial weakness in the labour market. As we noted last week, US unemployment is now above the three-year moving average. Historically, that has signalled recession.

One of our mentors would often ask; what is your quarrel with price? Despite meaningful weakness in the labour market, the long end of the US Treasury curve appears likely to break higher in yield from the recent consolidation pattern in the direction of the trend (chart 1). Our quarrel with price in the Treasury market is the fundamental weakness in the labour market which ought to reduce forward looking inflation pressure.

Chart 1

To be fair, the US Administration’s commitment to “run it hot” or maintain accommodative fiscal policy and the strength in business investment (AI driven capital spending) is genuine and likely supportive for economic growth momentum over the coming months. For Treasuries, we also note that the December consumer price index had a late cycle feel – driven by food and the shelter component (which tend to lag). However, inflation remains well above 2% (the Fed’s target) at a time when fiscal policy remains loose, financial conditions are easy and business investment remains firm. The path of future short-term rates under a post-Powell Fed is also a key question for markets.

The additional challenge for risk assets over the coming weeks is that the US Administration has re-started the trade conflict with Europe on the weekend over Greenland. While this is probably a negotiation tactic, the Donald announced that eight NATO members’ US imports will face escalating tariffs until a deal is reached in Greenland.

On Tuesday morning, the 21^st of January (10am New York time) the Supreme Court may rule that the Administration’s tariffs are illegal. That would likely amplify near term uncertainty on fiscal revenue and recent trade agreements. As we have noted, over the past few months, the broader context is that debt and deficit trends are not sustainable in the medium term across most of the advanced economies. This trend is likely to be amplified by demographics, rising real rates and defence spending. If there is no pre-emptive action, it is only a matter of time before advanced economies face a fiscal crisis. This likely explains the recent parabolic performance of gold and precious metals (chart 2).

Chart 2

Tactically, the potential renewed escalation in the trade conflict has been announced with equities near the record high (chart 3), sentiment euphoric and cash allocations near a record low. Risk compensation and implied volatility is also extremely low on a cross-asset basis. Credit spreads on investment grade (Chart 4) and high yield bonds are near the tightest on record. NVIDIA suppliers also halted H200 chip output on Friday (after the New York close) after China blocked shipments of the advanced AI processors. On the positive side, earnings momentum in key members of the supply chain (Taiwan Semiconductor TSMC) and China’s AI development (Gwen and others) remain encouraging. Nonetheless, equity risk appears fragile in the near term and we remain tactically cautious.

Chart 3

Chart 4

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