US-China Talks Turn Markets Bearish

MACRO FRAME

Global bond yields are breaking to multi-year highs simultaneously: US Treasuries are approaching their highest yields in 30 months, while UK 10-year gilt yields hit 18-year highs. The US-Iran deadlock has shaped expectations that a stalemate between the two countries is the new status quo, leaving April’s hot CPI and PPI to challenge the market’s prior assumption that the conflict would remain largely contained from a US macro standpoint, especially with WTI crude breaking above $105 overnight. While tech/AI leadership may continue to provide a floor, the combination of firmer energy-driven inflation, more constrained Fed easing expectations, and rising geopolitical risk leaves risk sentiment vulnerable to the Trump-Xi meeting.

STOCK INDEX FUTURES

Equity index futures fell sharply overnight as President Trump’s visit to China ended without any major breakthrough on trade, while Treasury yields and Fed rate hike expectations rose, further weighing on sentiment. The Nasdaq is leading losses reflecting a case of “buy the rumor sell the news” and larger profit-taking. In the near-term, the challenge for the equities remains higher Treasury yields (and Fed expectations), high oil prices, and rising geopolitical anxiety around Iran and Taiwan. Meanwhile, as earnings season wraps up, so does the tailwind effect it had on equities. Still, strong tech sentiment, mainly related to the AI space continues to underpin broader index performance, though it is likely face stronger headwinds to gains than before.

The US-China summit outcome turned bearish for risk assets as President Xi offered rather aggressive remarks toward Taiwan, while the US made little to no mention, raising tensions. Additionally, both presidents publicly agreed Iran cannot possess nuclear weapons, which some analysts have taken as a green light for US strikes to resume on Iranian infrastructure. That dynamic is likely responsible for the rise in oil overnight as energy markets near conflict highs.

Watch point: The lack of an outcome at the US-China visit has turned sentiment bearish and lead to a wave of profit-taking. Additionally, markets now fear a resumption of strikes against Iran and are beginning to price in the possibility of a rate hike from the Fed.

CURRENCY FUTURES

US DOLLAR: The USD index is 0.38% higher to 99.20. The bias for the dollar remains higher as the safe-have rally picks up. Meanwhile, the inflationary backdrop and expectations that the Fed may need to hike rates are also underpinning a stronger dollar. Odds of a December rate hike are currently 47%, a sharp rise from just over 25% priced yesterday morning. While last week’s labor data did reveal some notable spots of weakness, the overall market narrative is that the Fed will keep a hold on rates. Given such dynamics, the dollar is likely to find solid underlying support amid the continuation of the deadlock in US-Iran negotiations, while a resumption of strikes would further support for the greenback.

Watch point: Stalled optimism around a US–Iran resolution will continue to offer safe-haven support for the dollar. Fed policy expectations are likely to reinforce near-term dollar strength.

EURO: The euro is 0.41% lower to $1.1622. Dollar strength is likely to be the prevailing theme in currency markets with oil prices higher and jitters over geopolitics. For the euro, the status quo remains the same: the ongoing stalemate between US-Iran negotiators and resulting and closure of the Hormuz continue to pressure the currency. US Treasury yield differentials are also offering further support to the dollar against the euro despite expectations that the European Central Bank will begin hiking rates in June. Markets are pricing a 90% chance of a hike at the June meeting and are nearly priced for two additional rate hikes by year-end.

Watch point: While a June rate hike remains the favorable move from the ECB, a well-positioned policy stance could lead to a hold. However, recent inflation data out of the US likely underscores that policy will move moving upwards in the near-future.

BRITISH POUND: Sterling slipped 0.39% to $1.3347 as the political landscape pressures the currency. Prime Minister Starmer continues to face calls to resign following heavy losses for the Labour party in local elections last week. For now, Starmer has refused to resign, leading speculation over what a replacement would look like to pressure the currency. For markets, the question is what direction is fiscal policy heading. Investors are largely worried that a new Labour leader will increase fiscal stimulus and raise gilt issuance, weighing on the pound. The Sterling is likely to remain under pressure as long as political uncertainty persists. The concern for gilts and the pound is mostly surrounding potential candidate Andy Burnham. The pound is likely to remain under pressure until he clarifies his fiscal position in a more market-friendly fashion.

As for the Bank of England, money markets are pricing a 46% chance of a hike at its June meeting. However, weakness in the UK economy, is expected to act as a limiting factor to overall tightening from the BoE. While yesterday’s GDP data the strongest quarterly growth in a year for the UK, the impact of higher energy prices on the economy is expected to challenge further growth. The Bank of England will likely view the stronger-than-expected growth as reinforcing a cautious, gradual approach to any further rate moves.

JAPANESE YEN: The yen slipped 0.13% to 158.60 yen per dollar as the rise in energy prices overnight outweighed strong wholesale inflation data overnight, which has bolstered the case for the Bank of Japan to raise rates. Japan’s PPI reflected a common theme with the US in a sharp rise in wholesale prices; PPI inflation rose 2.3% in April to land at a YoY rate of 4.9%. Markets are pricing a 73% chance of a hike come June. Bank of Japan board member Kazuyuki Masu, said interest rates should rise promptly if there are no clear signs of an economic slowdown. For the yen, intervention alone is likely not going to be sufficient enough to strengthen the currency given Japan’s vulnerabilities to higher energy prices. The dollar has recovered over 50% of its losses against the yen since officials stepped in to prop up the yen.

AUSTRALIAN DOLLAR: The Aussie dropped nearly 1% to $0.7150, as risk sentiment soured overnight while copper and other commodity prices fell. Still, despite the overnight losses, the resilience in the Aussie despite unresolved US-Iran tensions, suggests markets view the energy shock as more inflationary rather than recessionary. These expectations should favor interest rate differentials which currently favor the Aussie. The Reserve Bank of Australia’s cash rate is well above most G10 countries and elevated inflation pressures, were present before the outbreak of conflict in Iran. Markets still imply around a 24% chance of a June hike to the 4.35% cash rate, but the probability of an August hike to 4.60% moved up to 70%.

Watch point: While a durable end to the war would alleviate downside risks to growth and moderate inflation pressures, ongoing pass-through into broader prices is likely to keep the RBA on a tightening path.

TREASURY FUTURES

Yields are higher across the curve, with the two-year breaking above 4% and the 10-year above 4.56%. Markets are seemingly beginning to price in meaningfully higher inflation; in the US, one-and two-year inflation swaps have both risen sharply in recent days, while Fed rate hike expectations have also increased, pressuring bonds. Rising yields are a common theme in the global marketplace currently, given the rise in energy prices. The bearish sentiment in the market is underscored by the largest net speculative short positions in bonds since December 2023. Even if fuel prices are ignored, the median and the trimmed mean inflation components are rising. Sticky prices have ticked back up above 3%, while the Fed’s supercore (services inflation minus shelter) broke above 3%. The readings indicate that there is more to inflation than the first-order effects from the oil shock.

Watch point: Fed policy is poised to stand pat for the time-being. The path to loosening has faded materially as inflation has evidently become more broad based.

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