The market has undergone a sustained correction since June. On one hand, the U.S. Dollar Index has broken above the upper bound of its trading range from the past year. Conversely, global equity indices, particularly those sensitive to the AI boom and U.S. dollar liquidity, have broadly pulled back. Within the U.S. stock market, a style rotation has occurred, with more defensive sectors gaining favor. The primary drivers behind this series of adjustments are the intensification of rate hike expectations and a marginal tightening of dollar liquidity.
In our earlier report, "Global Markets H2: Trading the 'Lagging Curve'," we noted that Federal Reserve Chair Walsh is likely to adopt a hawkish stance initially to establish authority, but the underlying economic fundamentals and financing environment for the full year likely do not support actual interest rate hikes, suggesting a policy stance that is "hawkish in name but dovish in reality." Following this current adjustment phase, the market may begin to trade on this "lagging curve" narrative. The U.S. Dollar Index could revert to its previous weak trading range, while tangible assets, industrial sectors, and technology maintain expansion potential. Additionally, financial deregulation could provide a boost to traditional cyclical sectors.
Liquidity: From Marginal Improvement to Marginal Tightening
From December last year to May this year, the Federal Reserve's balance sheet expansion (RMP) led to a gradual increase in narrow liquidity (bank reserves) from a low of around $2.9 trillion, marginally alleviating the liquidity strain triggered by government bond issuance since last July. Short-term market funding pressure eased, as evidenced by the declining spread between the Secured Overnight Financing Rate (SOFR) and policy rates like IORB and ON RRP.
However, as funding pressures improved, the pace of the Fed's balance sheet expansion slowed from approximately $40 billion per month in late April to about $10 billion per month currently. Concurrently, the marginal tightening effect of fiscal financing is strengthening. The outstanding U.S. Treasury debt surpassed $39 trillion in May, with market expectations suggesting the debt ceiling (around $41 trillion) could be reached as early as next summer. In next year's debt ceiling negotiations, a potential delay in passing a bill to raise the limit under the Trump administration could raise the risk of a U.S. debt default. An effective hedge is to accumulate funds early to buy time for negotiations. Indeed, over recent quarters, the U.S. Treasury has consistently raised its target for the Treasury General Account balance, absorbing liquidity and tightening reserves. The combined effect of slower Fed expansion and fiscal liquidity absorption ended the downtrend in the SOFR spread in June, reigniting funding pressures. This forms the crucial backdrop for the recent dollar strength and market adjustment.
Rate Hike Expectations: Raised High, Lowered Gently
The fermentation of rate hike expectations has exacerbated the tightening liquidity situation, driving the U.S. Dollar Index to break above resistance levels in late June. Looking ahead, we reiterate the view from our "Global Markets H2" report: U.S. economic fundamentals do not support an actual rate hike within the year. We anticipate that the currently elevated rate hike expectations and the strong dollar will be gently lowered over the coming months.
First, underlying economic resilience is not solid. The lower segment of the K-shaped economy—consumption, housing, and small businesses—remains weak and cannot withstand rate hikes. Small business recovery in this easing cycle has been sluggish, with weak hiring demand and a frozen labor market where hiring and separation rates are even below pre-pandemic levels. The Atlanta Fed's Wage Growth Tracker fell to 3.5% in May, with real wages even declining.
Second, the current economic operation heavily depends on an accommodative financing environment. For the lower K-segment, financing costs for consumer loans, auto loans, and small businesses are linked to policy rates. For the upper K-segment, the upturn in the investment cycle is highly dependent on loose bank credit. Historically, once the Fed begins a hiking cycle, bank credit conditions tend to shift from loose to tight.
Recent developments show that as U.S.-Iran negotiations progress and oil prices decline, inflation expectations have already started to recede—a fact acknowledged by Chair Walsh in a July 1st speech. Furthermore, the sharp decline in the Weekly Economic Index since June indicates that as the rush-order demand from the U.S.-Israel-Iran conflict subsides, actual U.S. economic growth may not be as robust as market expectations, with the Atlanta Fed having revised down its Q2 GDP growth estimate to 1.2%.
Markets: From Adjustment to 'Lagging Curve' Trading
We reiterate the judgment from our "Global Markets H2" report: the Fed's stance this year is likely "hawkish in name but dovish in reality." What may materialize under Chair Walsh this year is more likely financial deregulation for the banking sector to sustain the investment cycle's momentum and buy time for AI-driven efficiency gains. We do not deny that before inflation data shows a substantive decline, rate hike expectations may continue to ferment. "Authority-establishing" rhetoric from Chair Walsh and others about restoring Fed independence could remain key points that unsettle markets, sustaining dollar strength and prompting market adjustments in the short term.
However, we also highlight that the market is poised to begin "lagging curve" trading once rate hike expectations peak but the Fed refrains from actual tightening. This involves trading on the Fed's increased tolerance for inflation and economic recovery within an effectively accommodative monetary policy environment. At that point, the dollar could revert to the weak trading range of the past year, and market style leadership may also rotate back. We maintain a positive outlook on tangible assets, upstream sectors, and technology outperforming within major asset classes. We emphasize the overarching theme of "national security" and the two main lines of "resource and energy self-sufficiency" and "productivity enhancement," recommending countries, asset classes, and industry sectors positioned upstream in the raw materials and AI supply chains.
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