Since the pause on mutual tariffs began on April 9, markets have been adapting to a more optimistic global economy, ignoring fears of a slowdown. Various soft data indicators support this positive outlook. Expectations are that global growth will continue alongside steady disinflation. Central banks are also focusing on easing policies to help achieve this.

Key Risks

However, there are important risks to consider: the potential return of trade conflicts and inflation. The market often overlooks the risks of renewed trade wars since previous conflicts have seen quick de-escalation. As we near the end of a 90-day tariff pause, uncertainty remains, though markets seem to downplay concerns. Still, even small trade issues can change growth predictions and affect the markets. Inflation poses another significant risk, and it’s more likely to cause issues than trade conflicts. Strong economic activity driven by easing policies, tax cuts, and deregulation could lead to higher inflation. Although inflation is a lagging indicator, recent data, such as US PMIs, indicates growth. The rise in long-term yields, linked to stronger growth and inflation risks, is noteworthy. The 10-year US yield is at 4.45%, reflecting current risks, while the policy rate sits between 4.25% and 4.50%.

Inflation Risks

If inflation risks persist, long-term yields may increase, impacting various markets and future interest rate expectations. We’ve seen how the halt in tariffs boosted overall market sentiment. After the announcement, markets quickly adjusted their outlook for global demand, putting aside earlier concerns about widespread economic stagnation. This shift was evident in surveys and forward-looking indicators, particularly in the services and manufacturing sectors. This trend seems to be continuing, as consensus builds around the idea that growth can persist without reigniting inflation pressures. Monetary authorities have responded with a more supportive approach. This has encouraged capital to flow into risk assets, driving recent equity gains and narrowing credit spreads. The belief driving these movements is that central banks feel confident pausing or even easing in the upcoming months. Bond markets seem to endorse this view, though not without some caution. There’s a current tendency to rely heavily on past behavior. Prior trade disputes have followed a familiar pattern of sudden flare-ups, often followed by equally quick resolutions. Therefore, markets feel less need to react strongly until tangible measures are reintroduced. Yet, this mindset risks underestimating how even a minor change in posture could harm sentiment and disrupt investment flows, especially given how much pricing relies on future certainty. Goolsbee effectively highlighted that recent activity data shows signs of gaining momentum, particularly in consumption-driven economies. This can quickly lead to inflationary pressures, especially if monetary policy seems too loose in hindsight. While inflation may lag, forward indicators like PMI inputs and wage growth suggest that pricing power is returning in some sectors. This development is crucial for traders. The charts indicate that fixed income markets have started to react. Movements in long-term yields now reflect shifts in inflation risk premia, not just rate expectations. A rise in 10-year yields from 4.20% to 4.45% does not happen in isolation—it signals a reevaluation of the long-term real rate, affecting duration sensitivity and impairing convexity-neutral positioning. During his last appearance, Powell hinted that surprises on the inflation front could delay the easing cycle. This adds further volatility to terminal rate timelines. We see the ripple effects influencing equity volatility curves and correlations across assets. Maintaining short volatility positions or expressing carry-trade views has become costlier without tighter hedges. Given this context, the current pricing in rate forwards and volatility markets seems overly optimistic. Most metrics favor scenarios where no policy reversal occurs, downplaying tail risks. It’s not just about inflation exceeding targets; it’s also about how that interacts with limited fiscal space in larger economies. Legislators are unlikely to initiate large stimulus packages again if inflation returns, leaving central banks to act alone. We should closely monitor credit markets. If long rates continue to rise, funding costs across leveraged sectors will increase. Compression in high-yield spreads could quickly reverse if macro data confirms rising inflation. This could tighten financial conditions without central banks adjusting short rates. Shifting into shorter-term diagonals and reducing exposure to steepeners may limit volatility connected to yield curves. Positioning in breakevens and select swap structures now offers asymmetric payoffs for when inflation reports exceed expectations later this summer. While this shift may not happen immediately, the risk is more present than not if economic activity continues to grow. Future PMI reports and inflation data will guide whether these trades begin to unwind. For those engaged in derivatives or spread positions, reactions to even slight surprises are likely to be quick as current positioning lacks strong defenses. We expect volatility markets, especially in rates and FX, to respond more sharply than equity indices, given that equities are relatively insensitive to small shifts in monetary policy expectations during growth cycles. Close monitoring is essential, and adjusting exposures in line with inflation-linked instruments may offer better short-term protection. Create your live VT Markets account and start trading now.

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