If one had to choose a single word to describe financial markets in the first half of the year, it would be volatility.
And that volatility has set the stage for more of the same as investors continue to digest the implications of trade and fiscal policies in the United States.
Get Joe Brusuelas’s Market Minute economic commentary every morning. Subscribe now.
The dollar had its worst start of any year, accompanied by significant volatility in U.S. Treasury markets. Oil prices soared and then retreated to reasonable levels as OPEC+ increased production in the aftermath of hostilities in the Middle East. Equity markets tanked as policy uncertainty soared, only to recover to record highs.
The dollar was the first to fall
The dollar lost 10.4% of its value through July 7 this year. Against the euro, the dollar lost 13.8%. Against the Japanese yen, it dropped by 8.1%.
While the U.S. adopts policies that are weakening the dollar, ostensibly to reduce the cost of American-made goods to foreign buyers, the loss of confidence in the dollar will have long-lasting effects on portfolio flows into U.S. dollar-denominated assets.
A weaker dollar adds to inflationary pressures on the margin through the trade channel. In addition, a softer dollar discourages foreign investment in the U.S., which will have a long-term impact on economic growth. And it will tempt the U.S. to inflate its way out of those conditions.
Crude oil’s volatility
In June, the global economy was again rocked by conflict in the Middle East. Crude oil prices soared to $80 per barrel, only to quickly fall back to $65.
Since then, OPEC+ has said it would increase production to lower prices and gain market share as well as punish cartel members that violate quotas.
A selloff of 30-year bonds
While increased policy uncertainty accounts for the Federal Reserve’s wait-and-see stance toward lowering its policy rate, the bond market is not taking any chances. Investors are selling 30-year bonds that would be most vulnerable in the case of a downturn. Yields, as a result, are rising.
The impact of a weak dollar
Recent analysis by the Bank of International Settlements shows that Europe and other advanced economies have accumulated the largest share of U.S assets.
The attractiveness of U.S. government and corporate debt was fostered by an economy that could support higher interest rates. This investment was facilitated by the currency returns of a strengthening dollar and confidence in the safety of dollar-denominated debt.
But now, that flow of capital has been disrupted, and it will have a far-reaching impact on the cost of servicing the $36 trillion in U.S. public debt, all while tamping down investors appetite for U.S. private-sector debt.
Now that the euro-area nations are increasing military spending, international investors will be looking at an alternative to dollar-denominated assets, which will put downward pressure on the value of the greenback.
The equity market bounces back
Declines in equity valuations early in the year ended up setting the stage for a renewed appetite for risk once the administration retreated from the sweeping tariffs announced on April 2.
While valuations stand at or above record highs, the benchmark S&P 500 on July 7 stood 6.25% higher than the beginning of the year.
While we expect that it will take time for the tariffs to push inflation higher and consumer spending lower, further disruptions to trade and the dollar’s impact on investment flows will dampen firms’ willingness to borrow and expand.
Leading up to the financial crisis, the stock market suffered a crash at the end of June 2007, unsettling markets. But it wasn’t until the collapse of Lehman Brothers in September 2008 that the financial crisis took hold.
While the stock market eventually recovered, the long-term impact on investment and the economy’s potential was long-lasting as investors looked elsewhere.
The speculative crypto market
One of the candidates for “elsewhere’ is crypto currencies. If there is a parallel forming, the performance of bitcoin since 2023 is looking like what the public expects from the equity market.
Even as the large returns on bitcoin have returned to earth and even after its downturn in March, the market seems to expect bitcoin to continue its ascent.
The decreased cost of business operations
While the long end of the yield curve has risen, reflecting higher risk, the front of the curve is anticipating the easing of monetary policy if an economic downturn were to occur.
Money market rates, which determine the cost of day-to-day business operations, declined by roughly 20 basis points from the November election through early July.
Two-year Treasury bonds, which anticipate the direction in the federal funds overnight rate, dropped by 33 basis points over that same time, suggesting that the market is expecting the Fed to make one to two rate cuts.
The kink in the money market curve at one month will most likely correct itself now that Congress has increased the debt ceiling, avoiding the possibility of nonpayment of securities maturing in August.
Interest rates are lower
The calls for lower interest rates have not been completely ignored. While the front-end of the Treasury curve waits for the resolution of inflation pressures, 2-year bond yields dropped by 45 basis points this year through early July, while 5-year yields were 53 basis points lower and 10-year yields were 28 basis points lower.
The 30-year yield, which reached 5.1% in May, settled back to 4.8% in early July, with that experience giving an insight to what might happen if the latest round of tariff negotiations were to point to slower economic growth.
The 10-year Treasury
We expect the 10-year Treasury yield to trade between 4% and 4.5% under conditions of elevated volatility. We also expect it to finish the year near 4.35% with the chance of lower rates if the Fed makes any reductions.
Our forecast is for the Fed to cut its policy rate only once this year, most likely in December, as the economy chugs along at sub-2% growth and as central bankers assess the impact of tariffs and an expansive fiscal policy.
We do not see a large downward move in the 10-year Treasury. The economy and the labor market would have to crack for interest rates to move below the recent range established at the long end of the curve.
While volatility will remain elevated, we do not expect yields to decline on a sustained basis without the economy falling back toward recession.
Beyond the influence of monetary policy, interest rates are determined by expectations of growth and the ability to sustain higher rates of return. Low rates imply an economy unable to support normal rates of return on investment,
On July 7, the yield on a 10-year Treasury bond was 4.33%, which can be broken down to its components of the real, or inflation-adjusted, rate of 1.99% plus the compensation for the break-even rate of inflation of 2.34%.
Another model of the 10-year yield is derived from expectations of a federal funds rate of 3.64% plus a term premium of 0.64% to compensate for the risk of holding that bond until maturity.
The presence of a term premium accounts for the Fed not being able to sustain the funds rate at 3.64% over that 10-year period because of an inflation shock or a growth shock.
Range trading and a center of gravity
It takes a catastrophe to move long-term interest rates away from what were appropriate levels of risk and if that happens it takes years for the economy and the bond market to recover.
After the pandemic, it took three years for the markets to recover and respond to the delayed impact of the fiscal stimulus. Since 2023, 10-year yields have range-traded around 4.25%, which is its 52-week average.
We can expect that range to hold for as long as the economy remains at full employment or until inflation overwhelms household expenditures.
Corporate bonds
The yield spread between Baa investment-grade corporate bonds and 5-year Treasury securities increased to more than 200 basis points this year. Five-year Treasury yields have drifted lower since January, while corporate bonds remained near the top of their range.
This suggests the beginning of a loss of confidence in corporate securities should the economy weaken, while the 5-year Treasury is reacting to expectations of the eventual reduction in the federal funds rate.
The threat of volatility remains
Financial conditions are measured by price action and stability of financial asset prices. There has been a degree of co-movement of the VIX index of S&P 500 share price volatility and the MOVE index of Treasury market interest rate volatility.
Both indices are somewhat elevated after the short-term disruptions.
The takeaway
Financial conditions as measured by the RSM US Financial Conditions Index have returned to neutral levels of risk.
Despite pervasive policy uncertainty, equity markets have shrugged this off as bond investors again price in normal levels of risk.
