Walking blind

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Recency bias plays a big role in expectations and nowhere more so than in financial markets. Expectations for market prices and returns are conditioned by what has happened in the recent past. Breaks with prevailing trends and levels are met with shock and resistance. Big market moves are rarely reflected in the consensus and individuals find it hard to contemplate any large swings, let alone take any action to profit or protect portfolios from such events. The psychological tendency is to treat current market prices as reflecting a close approximation of fundamental value given the current economic and policy narrative and the market’s technical structure. Extended range trading periods, or the marking down of the price of volatility in derivative markets, adds to the complacent nature of investor behaviour and provides fertile ground for shocks when they eventually come. The rise in the 10-year US Treasury yield from around 50 basis points (bp) in mid-2020 to 5% at the end of 2023 was an example with the recency bias conditioning market participants to resist what was essentially a return of yields to more normal (i.e. pre-financial crisis and quantitative easing) levels.

Think big 

In conversations with clients this week, it occurred to me there is a current conflict between recency bias on the one hand and significant shifts in fundamentals on the other, the latter having the potential to provoke big moves in market prices. An example is the dollar. The consensus is probably that the dollar weakens a bit more against other major currencies, reflecting potential changes in global allocations in equity and bond portfolios in response to US policy decisions. But investors find it difficult to think about how far this might go. There is a reluctance to forecast - as forecasts are usually wrong. But we should consider changes, which are of a magnitude to really have consequences, no matter how uncomfortable that is. I suggested in one client meeting that the euro-dollar exchange rate (currently $1.14) could go as high as $1.35-$1.40 in a dollar bear market. The very thought of such a move was seen as a shock. But it could happen.

In the early years of the euro’s life, it strengthened against the dollar reaching $1.60 in 2008. The dollar’s accelerated decline at the time was caused by the sub-prime crisis but even with that, the euro remained above $1.20 until 2015 when the European Central Bank took interest rates into negative territory.

Recipe for dollar weakness 

The US Administration’s policy on trade could still hit the US economy hard, causing a recession and a stock market adjustment. The US’s aggressiveness towards the rest of the world could impact on global capital allocations. If that is a real risk, then it has only just started and is hardly evident in balance of payments data. If, over the medium term, the US must come to terms with its budget deficit that would classically be negative for the dollar, as it would entail higher taxes, less spending and lower interest rates, as per the Mundell-Fleming model (i.e. the short-term relationship between an economy's nominal exchange rate, interest rate level, and economic output).

If the US really wants to rebalance the global economy, then there may also be a policy preference for a weaker dollar (as suggested by some US Administration commentators). A change in leadership at the Federal Reserve (Fed) that allows a more direct influence of White House biases in monetary policy might also be met with currency weakness. Exchange rates also overshoot, and momentum plays a role. The levels I suggested are not totally crazy when you consider the ingredients for a bearish dollar view.

And upside for Europe?

The other side of the currency pair should also be considered. The current growth and rate argument for a much stronger euro is not compelling. Yet we need to consider what might happen with Germany’s fiscal boost – €1trn over the next decade (a number close to 25% of Germany’s current nominal GDP). Spent properly this could help raise the Eurozone’s potential growth rate, with positive economic effects on Germany itself and its near neighbours. By extension, this may raise Europe’s real neutral interest rate and the structural level of German government bond yields. So, between the US and the Eurozone, the growth differential may narrow, as might the interest rate differential. If there is to be higher US inflation, this would also require some offset in the exchange rate.

This is not a forecast but it is interesting to contemplate the exchange rate going back to levels it has been at before. The next step in the thought process would be what the implications would be. A continued euro strengthening would be a problem for European exporters (although growth was stronger in the mid-2000s when the euro was very strong, and a weaker euro has not done much to boost growth recently). A weakening dollar could eventually help reduce the US trade deficit and help secure continued financing for the Treasury market by making US bonds more attractive on a currency adjusted basis. Of course, along the way, the currency adjusted returns for European (and other non-US) investors in US assets would be reduced (a factor in eventually causing an overshoot). 

Big cycles 

A euro/dollar move to, say, $1.30 over the next couple of years would be associated with something around $1.50 for the dollar against sterling (assuming the sterling-euro rate remains quite stable). The yen is a different story, but a generalised dollar decline could take the Japanese currency back to pre-Fed tightening levels below ¥120 (accentuating the concerns that Japanese investors are reducing their exposure to US assets). These levels might seem crazy, but the history of currencies would suggest they are not impossible – the dollar has gone through huge cyclical swings over recent decades. In my career, I have seen the sterling-dollar rate at $2.10 and $1.04!

Long-end bond concerns 

Other key areas of client concern, especially amongst those heavily exposed to fixed income, are the long-end of government bond yield curves and inflation. As discussed briefly last week, there are few developed countries that do not have a fiscal problem. Yields on long-term debt hardly compensate investors for the risks associated with rising debt levels and the (remote) possibility of monetisation, and long-duration fixed income assets have underperformed in recent years. Should we contemplate the risk of yields going much higher and curves becoming much steeper? The spread between 30-year and five-year US Treasury yields is around 90bp now. It has been as high as 250bp. Given the current five-year 4% yield can we contemplate 30-year yields at 6.5%?

3% inflation again?

I’m not sure that markets are ready for another inflation shock either. If there is one, it would likely be confined to the US. There is a view that tariff costs will show up in the consumer price inflation data in the next few months given the lags that operate in sectors like retail. In May the US’s headline inflation rate was 2.4%. Crude oil prices are up more than 20% since the start of June with US gasoline wholesale prices up 15%. Add in some tariff effects and there could be quite a jump in the inflation rate. It’s not so difficult to see a 3%, or even higher, inflation rate for June or July. With the Fed being quite unequivocal in its “on hold” message this week, this would be an issue for investors in US rates markets.

Tactical risk off and structural risks 

The US macroeconomic outlook is messy. Markets could get messy as well. Short-duration credit, high yield strategies and short-duration inflation-linked strategies should provide a lower risk profile if we see actual market volatility increase in the weeks ahead. An inflation bump, weaker data and ongoing policy uncertainty provide the threats to riskier asset classes but with US real yields still above 2%, a bias towards fixed income performance over equities remains my core expectation.

Performance data/data sources: LSEG Workspace DataStream, ICE Data Services, Bloomberg, AXA IM, as of 19 June 2025, unless otherwise stated). Past performance should not be seen as a guide to future returns.