Top of the Morning: CIO Strategy Snapshot - Policy puts vs. errors

Hi everyone. Dan Cassidy here. Welcome back to the UBS Market Moves podcast channel for top of the morning of the CIO Strategy Snapshot.

The S&P 500 rose 13 basis points last week, marking the seventh straight positive weekly return. But the real story was the jump in rates with Treasury yields surging between 18 and 25 basis points fueled by concerns about sticky inflation. Now with the unofficial start of summer beginning this coming weekend, a question that investors may be asking is whether they should sell in May before they go away.

So joining us for the conversation today on this Monday morning, glad to welcome back to top of the morning, Jason Draho, Head of Asset Allocation for the Americas from the UBS Chief Investment Office. Jason, we were saying before we start here, it is beginning to feel like summer here in New York. So it is welcomed, I'm sure, by many, myself included.

After a hit or miss spring, it's been nice to see some warm weather. So yes, happy Monday. Good to be here.

Great to have you back, Jason. So let's begin with a quick recap of market performance last week. A lot going on, though what from your vantage point was most notable?

Well, you mentioned the S&P 500 was up last week, only 13 basis points, but it was the seventh consecutive week in which it was positive. But I wouldn't say it felt like a good week from investors, and not just because on Friday, the S&P fell 1.25%. The other parts of the market of equities were down.

For example, the small cap index to Russell 2000 was down 2.7%. Although there wasn't necessarily clear style or factor kind of rotation, you saw some defensive sectors underperform because they're more rate sensitive, others kind of rallied. The real story was, you mentioned, was the surge in treasury yields.

So across the whole treasury curve, from the two-year to the 30-year, they went up between 18 and 25 basis points. Those are led by kind of the five and 10-year, both up 25 and 24 basis points, respectively. The 30-year yield is now at 5.11%.

It was up 18 basis points last week. This is the highest level since 2007. So 19 years.

Of that rate move, I'd say about two-thirds was due to higher real rates, one-third due to higher inflation expectations. And that applies across the yield curve. Essentially, what the market is telling you is that the Fed has to hike to cool the economy, kind of raise real rates to kind of slow things down because it's worried about inflation.

Just on that, the market pricing now basically has no cuts implied. There's a small, small probability of a cut later in the summer. But basically, by March of next year, the market's fully priced and more than one full hike for the Fed.

Moving rates is not just a U.S.-specific story. It was kind of a global story, especially if you look at long-end yields just for some perspective. The 30-year gilt, that's the UK government bond, it reached 5.85%.

It's highest level since 1998. So we're coming on 30 years there. The 10-year JGB, the 10-year Japanese government bond, went to 2.77%.

That's the highest since 1997. It's kind of also reflected of higher central bank expectations overall. So the market's pricing three hikes for the Bank of England and the ECB by March, two by the Bank of Japan.

So it's kind of across the board. Sticky inflation and concerns about sticky inflation are certainly a key part of this. But they also reflect some various fiscal challenges, possible fiscal expansion.

There's reports out of Japan overnight on that front. Domestic politics, certainly in the UK, where there's a potential change in leadership. And then overall, the potential prospect of greater government bonds apply.

So that was the real story last week. It's kind of the bond market more so than the equity market. Jason, you did mention sticky inflation.

We did receive inflation data for April last week. What was the main takeaway? Well, if we look into some of the data, we got April CPI data and PPI data.

I'd say it was a little bit higher than expected, certainly for CPI. But PPI was far above expectations. Just a couple of numbers.

If we look at headline and core CPI on a month-for-a-month basis, they came in at 0.6% and 0.4% respectively. Consensus expectation was 0.6% and 0.3%. The big miss was on PPI.

The overall PPI was expected to be 0.5% a month. It came in at 1.4%. You strip out things like food and energy trade.

It still beat expectations. I got 60 basis points versus 30 expected. I'd say these misses could be tolerated if it wasn't for the fact there's a couple other considerations.

I think that's really kind of what helped spook the markets and caused this rate rise last week. One is that the higher inflation in the US was not just oil-related. There are other components that indicate a little more of a cyclical demand story.

A lot of it pertains to AI. Huge, obviously, investment on AI CapEx. We've talked about this before.

That's pushing up semiconductor prices, memory chip prices. That's actually notable in some of the inflation data. Likewise, there are software upgrades to reflect some AI tools.

That's causing their prices to go higher, which doesn't necessarily reflect also quality improvements. It's not the way the CPI data is fully adjusted for. But the bottom line is that there is this cyclical strength, especially tied to AI, that is helping to lift inflation, which means once oil goes lower, presumably it does, that doesn't mean that there's other factors that can keep inflation a little bit elevated for a while.

The second factor goes back to oil. There's no real clear progress between the US and Iran in terms of negotiations for a sustainable peace deal, which means the longer this persists, oil prices could easily go higher before they go lower. I think the market's investors had some optimism that the meetings between President Trump and President Xi of China last week, one of the outcomes would be that China would then maybe pressure Iran to reach a deal, open the Strait of Hormuz, and doesn't appear likely that- No evidence yet.

No evidence yet that China's going to apply that pressure. So out of the story last week is that the inflation dynamics, a little worse than expected, but I think the underlying details also give investors a little bit of caution that perhaps disinflation won't resume quite as quickly as they were hoping for. So Jason, to tie in your latest blog into the conversation, a title is Policy Puts Versus Errors.

And this, by the way, now available up on ubs.com slash CIO for our listeners. Though within the blog, Jason, you do mention that the near-term market outlook will hinge on how policy markets respond to the latest inflation news. So what did you mean by that?

Well, we can think of like policymakers will either help calm inflation and rate concerns by exercising what I call policy puts, and I'll get into the details, or they can exacerbate them by making a policy mistake or policy error. Now, it's easier to think about in terms of the Fed. When we would talk about a Fed put, we would normally mean the Fed's cutting rates to support growth.

The market's going to rally on that. But the put in this case is different when it's high inflation is the problem. And then we have the additional wrinkle that Kevin Warsh is now the Fed chair.

I mean, he was confirmed by the Senate. He hasn't been sworn in, but this is a technicality. It's often the case that the markets will test a new Fed chair under inflation-fighting kind of credibility.

Right of the gate, that can mean rates go higher, equities go lower. And this transition, given the inflation environment, should be sort of no exception. So in this case, what does a quote, unquote, Warsh put look like?

And perhaps because cutting rates won't necessarily ease the market, given the market's pricing hikes, what Warsh put could look like in the circumstances actually is to sound tough on inflation, especially at his first kind of press conference that would be posted at FOMC meeting on June 17th. And while that may actually cause the markets to price and even more Fed rate hikes, the alternative appearance of complacent inflation could lead to even a bigger rate rise if investors believe that a Warsh-led Fed is making a pause here and will be forced to hike rates even more later on because they could have had a chance to cool and they didn't. So I think that's something to look for, like how does the Fed and then how does Warsh handle this inflation dynamic?

And do they kind of provide essentially a put for the markets or does it actually make it sort of, you know, worse? So Jason, we've touched on the Fed put, but what about the other Trump put that you discussed? What does that entail?

So the idea of sort of the other Trump put reflects the fact that, you know, there's a, you know, certainly during Trump 1.0, kind of a thought is that there's a Trump put on the market, specifically referring to equity markets. He follows the stock markets and if the equities go, you know, too low because of some sort of policy actions, trade for example, that would lead to sort of you pivoting on that policy. The other Trump put refers to a put on the treasury market.

Interest rates were very low during Trump 1.0, definitely much higher in Trump 2.0. And if, you know, when you're focused on affordability concerns, rates going higher, mortgage rates going higher, that's a problem. So you don't want, you know, treasury prices to go too low, it means rates go higher.

So that's the idea of sort of this other Trump put. Bringing us back to like, what does it mean from a policy perspective and a policy put versus policy error? You know, this pertains specifically to reaching a deal with Iran that would open up this trade of hormuz.

There are many factors that go into it, you know, but if we just think about, you know, the U.S. perspective, affordability, the economic considerations have to be something the administration is thinking about. You know, we've talked about inflation rising overall, but just a couple of things that's specific that people would feel sort of on a day-to-day basis. The national average price of a gallon of gas is now 50% higher than it was in late February, $4.50 versus $3.

And then according to Mortgage Daily News, the average 30-year fixed mortgage rate is now over 6.6%. Late February, it was below 6% for the first time in a number of years. So any sort of deal that would enable oil to flow, kind of start flowing through the straight of hormuz, you know, normally or more normally by the end of the quarter would help bring, you know, oil prices lower, gas prices lower.

Inflation concerns would abate and interest rates would decline in that case. So from an economic perspective, you know, essentially a deal will reflect an activation of this other Trump put that I'm sort of referring to, or in order to keep kind of treasury rates, you know, from going higher. And this is not sort of just a conjecture.

If we go back to April of 2025, during sort of the liberation day, the equity markets were selling off on the threat of much higher reciprocal tariffs. It wasn't the S&P being down 20% that caused a 90-day pause on the reciprocal tariffs. It was stress in the treasury market that caused them to ultimately back off.

So there's certainly something. We've seen this before. There's something there.

Now, there's a question whether like in this situation, you know, is there really a Trump put in this case? Because, you know, it takes two to tangle. Iran has to agree to some sort of deal, open up a straight of hormuz.

And so you can say, well, it's not really a policy error. This is just what it is. From the market's perspective, it's sort of like a distinction without a difference.

Because if you're an investor, all you really care about is, you know, the price of oil and is a straight open up. And however you get there is how you get there. So that is something that to be watched for in the, you know, in the coming weeks.

There's a lot here to be mindful of in consideration of these developments and potential policy puts and errors. Jason, let's end as we typically do, spending a few moments here on the investment outlook, as well as positioning guidance. What are you recommending that investors do at the moment?

Well, I think about the very near term, talking about these puts, I'd say the window to sort of exercise them to calm the markets in the near term, you know, won't be open for too long. I think for the Fed, it probably won't last much longer than Warsh's first press conference on June 17. And for US or India, probably not much longer, maybe sooner than that.

And that's the near term. So it can lead to some market choppiness. You know, it's often the case that we get sort of periods of consolidation of these very rapid moves.

And keep in mind that the S&P is up, you know, like 17%, you know, in those seven weeks, momentum has been very strong. So you might get some sort of, you know, kind of consolidation phase. You know, these policy puts versus errors could sort of compound that in the near term.

If we step back from the next couple of months, but think about the more medium term, at least kind of through year end, then it's more of the economic fundamentals that take a more important role rather than, you know, these kind of these policy situations. And the fundamentals remain sort of, you know, relatively supportive. Well, it's true that inflation is moving in the wrong direction.

If I were to characterize the economic regime, the macroeconomic regime that we have right now, I'd still say it's reflationary and not stagflationary. Why is that the case? Well, the US economy grew 2% in Q1.

And it's showing little signs of slowing down halfway through Q2. We got April retail sales data last week, it was a little bit better than expected. And your credit card data suggests, you know, healthy spending in April.

Not all of this is not surprising, because there was bigger tax refunds, the expectation would there be some sort of stimulus. And so that is playing out. We still have this enormous amount of AI capex related spending that should be kind of supportive.

And if ultimately, oil prices do come down later in the year, we should start to see kind of real wage growth pickup. And that supports kind of the overall economic growth. So then we think about, you know, sort of reflationary kind of macro conditions.

You know, the market's pricing for the Fed hike by March. You know, we're still the view that the Fed is biased towards easing, we have December and March as cuts. Because ultimately, again, the inflation data should come down enough.

And we'd have, I think, a Fed that would be leaning more towards ultimately looking to normalize policy a little more. But it's going to take, you know, six months of data for them to feel comfortable. I think that's kind of why we push back our timing overall.

So given all this, you know, still constructive on sort of the medium term outlook, still constructive on equities, you view them as attract them. If inflationary macro environment, you know, is good for equities, even if it's not in the short term, necessarily good for bonds, as ultimately transition to inflation, going lower rates going lower, that again, sort of as a macro condition is good for, you know, for markets kind of across the board. So constructive on equities, you know, these yields, they start to look attractive for definitely for for bonds.

But you know, because your term rates can certainly go higher in the next couple of weeks before they start to go, you know, lower. So, you know, choppiness, perhaps in the next month or so, but still ultimately, I think a relatively constructive view, if you think about the year end time horizon. Jason, with so much going on, appreciate the clarity and guidance when it comes to positioning a very productive conversation to begin another trading week.

And do thank you for dropping by, Jason. You're welcome. Have a great, great long weekend to start the summer.

You as well. Thank you, Jason. Again, we've been joined today by Jason Draho, Head of Asset Allocation for the Americas from the UBS Chief Investment Office, referencing Jason's most recent blog, which, again, available now up on UBS.com slash CIO.

A title is Policy Puts Versus Errors. So for clients of UBS, please reach out to your UBS financial advisor if you would like to receive a copy of Jason's blog directly. From UBS studios, I'm Dan Cassidy.

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