The three things investors should know about this week.
US equities continued to rebound, but US borrowing costs rise as investors are getting more worried about inflation.
Moody’s became the third credit rating agency to strip the US of its perfect AAA status, due to concerns about growth and debt.
The US won’t of course likely directly default. But borrowing cost worries could add downward pressure to the Dollar and upward pressure to inflation.
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Summary
Investor optimism about rebounding equity markets was tempered by concerns over rising borrowing costs for the US government. The downgrade by Moody’s and fiscal concerns over the President’s “Big Beautiful Bill” are adding pressure on longer-term borrowing costs for the world’s biggest economy – which could impact other economies as well. So far, the “hard” (non-sentiment) economic data don’t point to either a sharp slowdown in growth or a recovery of inflation. However, as months pass and tariffs remain, markets are worried that as companies run out of pre-tariff inventories, they could significantly increase prices, especially if oil prices rebound. With pressure on bonds and inflation worries, equities seem like the safer bet for asset allocators, but investors still need to consider the balance: if corporations are pressured to absorb the tariffs, it could mean lower margins for them.
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When I was introduced to finance, exactly 20 years ago, my new boss asked me which side of the desk I wanted to pick. On the one side, bonds. “That’s where the smart, macro people sit. It’s slow but interesting”. On the other side, equities. “This is the fast-moving market” he simply said. I chose action. But it remains true, to this day, that bond markets are a much better indicator of the overall economy than shares.
Equity markets may be rebounding, but, ultimately, that’s what they do. Unless faced with systemic shocks, equities tend to mean-revert towards their upward trend, especially when they get assurances from the central bank that the system will remain liquid and the cost of money will not soar.
But bond markets, the more important economic indicators, are getting worried. US longer term borrowing costs have been going up, as investors begin to fear that inflation will rebound. The 10y US Treasury is at 4.4% and the 30y Treasury hit 5%.
This comes despite the latest US Inflation data which saw prices in the US rise a mere 2.3%, below expectations for the second consecutive month,
Markets recognised that benign readings are mostly due to lower energy prices and softer demand for items like airline tickets (tourism in the US has taken a hit lately). However, investors acknowledge that:
Energy prices are below their usual range and could mean revert.
2.Tariffs on imported goods are just now beginning to show up in the data.
3.Higher inflation expectations from consumers have a habit of becoming a self-fulfilling prophecy.
4.Lower CPI may be a symptom of more sluggish demand, as core retail sales (excluding energy, food and other volatile parts) in the US dropped by 0.2%.
Adding to borrowing cost angst, are concerns that the Republican “Big Beautiful Bill” (a massive legislative package proposed by House Republicans in 2025 to enact the President’s key policy priorities for his second term) will not be fiscally neutral, but significantly add to the deficit.
Friday’s downgrade by Moody’s, the last rating agency that rated US debt “perfect” AAA, may well increase pressures on American yields, especially long-term ones (where both inflation and mortgage rates live). Adding to long-term debt worries (134% of GDP by 2035), and widening fiscal deficits, Moody’s also highlighted a fiscal spiral, which becomes worse as debt servicing costs rise. The impact of recent policy decisions (tax cuts, tariffs) is seen as worsening the fiscal outlook.
The US won’t of course likely directly default. It has already broken the link with Gold since 1971, so it can always print money to pay off its debts. Its status as a global reserve currency all but ensures that the government will be able to spend as much as it needs to. Despite the publicity around Debt Ceiling battles, Congress has never failed to pass resolutions to fund the government. But borrowing cost worries could add downward pressure to the Dollar, which has so far lost recent gains, but not yet much beyond that.
Additionally, they could pressure consumers on the upside, as borrowing costs rise. Younger workers could find themselves not being able to climb the housing ladder. Businesses could have a tough time refinancing their debts. More importantly, the government would find it even harder to refinance itself (nearly $10tn of debt to be issued in 2025), with a lot of it coming in the second half of the year and the Republican Mega Bill still to be discounted.
As US borrowing costs rise, so do the rest of the world’s, especially British yields which tend to be more closely correlated. The US 10-year yield is still the bedrock of most global asset allocation portfolios and global-risk free rate.
Meanwhile, the White House is pressuring corporations to keep prices down and absorb the tariffs themselves. This can happen for a short while, but as pre-tariff inventories are reduced, then we could see surges in inflation and possibly lower margins as firms will not want to alienate their client base.
So what is the big picture?
The economic “hard” (non-sentiment) data in the US don’t yet support what “soft” consumer sentiment data suggest, i.e. a sharp economic slowdown and rising prices. But the longer consumer uncertainty persists, the more likely is that it will affect actual consumption which is 70% of GDP for most developed economies. Inflation remains consistently below expectations, but there is a strong probability that it will pick up after pre-tariff inventories are depleted.
Bond markets are aware of these risks. Rising long-end borrowing costs mean that bond investors fear more the probability of high inflation than the probability of more sluggish growth, as tariff costs can be somewhat mitigated with tax cuts, deregulation and possibly some of the trade/business deals the US President has been signing. Additionally, they reflect the rising probability of higher debt issuance to cover rising deficits and a weaker Dollar. Equity markets, on the other hand, seem less perturbed as higher inflation expectations, don’t hurt equities as much as they do bonds, or cash, which have smaller returns and are more easily eroded by rising prices. However, investors should be considering the impact on margins even in equities, if political pressures towards Main Street to absorb the tariffs accentuates.