Global markets have entered a corrective phase following a steep rally, with the semiconductor sector leading the pullback since June.
In previous analyses, we noted that while the overarching market cycle is not over, the intensifying conflict between robust financing demand and tight liquidity, combined with elevated market crowding and leverage, suggests a period of consolidation is likely before liquidity conditions ease. Looking ahead tactically, we believe the global market adjustment may persist into the third quarter, with risks stemming from monetary policy uncertainty, rising financing pressures, and potential spillovers from markets like Japan and South Korea.
Strategically, however, we reiterate that the technology rally is poised to resume after this intermission, and we maintain a positive outlook on broadly defined safety assets. It is important to note that post-intermission, market strength is expected to diffuse within the upper segment of a K-shaped recovery driven by security and investment themes. Beyond AI hardware, sectors such as AI applications, industrials, and resource commodities are also likely to commence their own second-half rallies.
Internal US Market Risks: The Widening Gap Between Monetary Policy Uncertainty and Strong Corporate Financing Demand
On one hand, a lack of consensus exists on the Federal Reserve's precise actions under a potential new chair, leading to high uncertainty and a market bias towards preparing for a worst-case scenario. The nominee's limited public appearances and reformist stance have disrupted the post-2008 market-Fed dynamic of "expectation management, market pricing, and expectation fulfillment." Given past political pressures on Fed independence, markets are naturally skeptical of a new chair's autonomy. To rebuild credibility, the new leadership is likely to adopt a stance perceived as "rule-bound and market-ignoring."
Since March, supply-side shocks, primarily from oil prices, have caused nominal inflation to spike and retreat. This context makes a strict hawkish interpretation of the new chair's stance likely, explaining why market expectations for rate hikes have surged significantly since March despite relatively stable long-term inflation expectations. Moving forward, until specific reform conclusions are provided by key working groups, the market will struggle to form a consensus on new monetary policy rules. In the face of significant data volatility, the tendency will be to position for the tightest possible monetary policy outcome.
Simultaneously, financing pressures are rising sharply. Since the Federal Reserve reduced its balance sheet runoff pace in late April, the phase of marginally easing US dollar funding conditions has ended, even as the balance sheet continues to expand. Overall liquidity remains relatively scarce, elevating liquidity risks. Starting in June, factors like the tax season and Treasury General Account (TGA) management have begun to highlight the issue of fiscal operations draining liquidity from markets. We anticipate financing pressures could intensify further.
On the fiscal front, the US Treasury is projected to issue a net $671 billion in bonds in Q3 (vs. $189 billion in Q2), with $367 billion in medium-to-long-term debt. This represents a substantial increase in both volume and duration compared to the previous quarter. As noted in prior research, the TGA balance is likely to remain elevated (around $950 billion or higher, compared to ~$750 billion currently) to hedge against next year's debt ceiling risks, which will continue to drain system liquidity.
Regarding corporate financing, the AI supply chain's upstream and midstream segments heavily rely on corporate debt. Net corporate bond issuance in Q3 could exceed $460 billion (up from $423 billion in Q2). This risk is particularly noteworthy. Over the past year, net financing for US Information Technology and Industrial Manufacturing sectors has grown rapidly, reaching $125.11 billion and $20.43 billion respectively in Q2. Given the rapid consumption of free cash flow by cloud providers, we expect this trend to continue into Q3. Notably, while Credit Default Swaps (CDS) for tech firms—reflecting default concerns—have risen recently, investment-grade corporate bond spreads for the sector remain near historical lows. This suggests markets may not be fully pricing in debt financing stress. A significant widening of corporate bond spreads could pressure equities.
The AI downstream segment relies heavily on private credit. Bank lending to non-banks, a key funding source for private credit, is projected to increase by another $79 billion in Q3 (following a $76 billion rise in Q2). The growing tension between strong financing demand and expectations for tighter monetary policy is amplifying market volatility. Indeed, mirroring policy expectation swings, bank lending standards, which had been easing since mid-last year, tightened again in Q2, increasing pressure on private credit.
Financing pressures are significantly negatively impacting market pricing. Since late May, despite a decline in the 10-year breakeven inflation rate as oil prices peaked and retreated, a sharp rise in 10-year TIPS yields has pushed long-term rates higher. This specific rate configuration—rising real yields alongside falling inflation expectations—typically benefits the US dollar but weighs on equities and resource commodities. Specifically, the failure of nominal 10-year Treasury yields to decline amid disinflation tightens global dollar funding conditions, while disinflation combined with higher real financing costs squeezes pro-cyclical, pro-inflation assets like gold, silver, and copper. Considering the levels of both real financing rates and financing demand, pressure in the US corporate bond market has reached historically high levels. Any further increase could trigger a sensitive market reaction.
External Shocks from Japanese and South Korean Markets
Monetary policy expectations between the US and Japan are the primary driver behind the recent yen weakness. The yen has depreciated significantly this year, with the pace accelerating recently, pushing the USD/JPY pair above 160—a level not seen in nearly four decades. Notably, the yen's movement has decoupled from the US-Japan interest rate differential. Even as the Bank of Japan enters a hiking cycle, with the 10-year JGB yield rising above 2.8%, and the rate differential narrowing from 210 bps at the start of the year to around 170 bps, it has failed to stem the yen's decline. The dominant factor is the divergence in monetary policy expectations. The Fed's hawkish signals in June, emphasizing inflation's influence on policy, coupled with oil prices rebounding nearly 20% from early July lows, have fueled expectations for further Fed tightening, driving the yen's recent depreciation.
Investors should be wary of potential market turbulence triggered by a reversal of yen carry trades. Despite the narrowing interest rate differential, yen weakness has further catalyzed carry trade activity. Metrics indicate yen carry trade positioning is near historical extremes. Research suggests the current Japanese market environment shares similarities with the period preceding the August 2024 carry trade reversal. Looking ahead, if the Bank of Japan tightens its guidance, intervenes further in forex markets, or a US liquidity squeeze cools global AI trades, a shift from yen depreciation to appreciation could occur more rapidly than in traditional rate-differential-driven scenarios. A reversal in yen carry trades, amplified by shifting exchange rate expectations, could act as a contagion channel, depressing US equity valuations through cross-market deleveraging and rising volatility. Historically, during periods of sustained yen appreciation, global equity markets have generally faced pressure.
South Korean equity market volatility has increased, with severe capital flow divergence. Since late June, the global semiconductor sector, exemplified by South Korean stocks, has seen a pronounced correction with heightened volatility. Major stocks have retreated significantly from their peaks, dragging down the US Philadelphia Semiconductor Index in sync. Concurrently, following substantial prior gains in the Korean market, capital flows have diverged sharply. In June, Korean retail investors were significant net buyers, while domestic institutional investors and foreign investors were substantial net sellers. The degree of market disagreement on capital flows has reached historically high levels.
Deleveraging triggered by an equity market correction could spark volatility across the global semiconductor sector and broader equities. The South Korean market currently exhibits high leverage levels, with concentrated margin debt. Additionally, the scale of Korean leveraged ETFs remains substantial, with continued strong weekly inflows. The market's structural fragility—characterized by high concentration, high capital flow divergence, and high leverage—poses a transmission risk to global markets. Notably, since April, capital flows in Korean and US tech sectors have been highly synchronized, increasing the daily return correlation between the Korean semiconductor sector and the Philadelphia Semiconductor Index. If expectations for US dollar liquidity tighten further, or if expectations for memory chip prices, AI capital expenditure, or cloud provider cash flows deteriorate significantly, a decline in Korean stocks could first trigger forced selling by retail margin accounts, leveraged ETFs, and derivatives. This could then transmit to the US semiconductor sector via foreign fund redemptions and reduced risk budgets at global tech funds. Against a backdrop of rising financing needs for US tech firms but tightening liquidity, a US stock decline would lower collateral values, tighten financing conditions, and potentially exacerbate a global equity sell-off.
Digesting Risks in the Intermission, Embracing New Opportunities in the Second Half
In capital markets, risk and opportunity are often two sides of the same coin. The key question is whether the fundamental logic supporting the current cycle has changed. We lean towards the view that structural factors remain intact, and opportunities for a cyclical upturn persist after this mid-cycle adjustment.
From a fundamental perspective, the global K-shaped economic trajectory is likely to continue. This implies that, on one hand, the AI-related investment cycle persists, supporting US real economic growth and corporate earnings. On the other hand, the foundation for a wage-price spiral is absent. Examining alternative data favored by the potential new Fed chair reveals high-frequency job openings remain low, small business hiring demand is weak, wage growth is likely to stay subdued, and real disposable income has already turned negative year-over-year.
Based on the judgment that the lower segment of the K-shaped economy will remain weak long-term, we believe the liquidity tightening driven by rate hike expectations will not persist indefinitely. As mentioned, the upper segment of the K-shaped economy still requires substantial capital investment. Initiating rate hikes or further liquidity tightening would materially impact private credit and corporate debt, thereby affecting financing for the entire AI supply chain. Moreover, the lower segment tied to broader US households is already relatively weak. Since financing for small businesses and household consumption is directly linked to short-term rates, any initiation of hikes or sustained high hike expectations could accelerate weakness in consumption and housing, ultimately reviving expectations for rate cuts.
Contrary to a "strict hawk" image, the potential new Fed chair's approach, as suggested by the setup of the inflation framework working groups, appears pragmatic and flexible. This includes acknowledging the limited role of monetary policy against certain inflation sources and seeking more flexible inflation targets and indicators that better reflect actual economic conditions. This approach seems designed to grant the Fed greater flexibility in navigating a K-shaped economy, fiscal dominance, and the AI wave. In fact, alternative indicators suggest US inflation, particularly on the consumption and wage fronts, may be much weaker than official metrics imply. Therefore, we judge that recent risk-off sentiment and extreme rate hike expectations largely reflect uncertainty before new monetary policy standards are established. As working groups provide more details and markets become accustomed to the new framework's operation, this uncertainty should gradually dissipate. Should one-sided tightening expectations then begin to ease, a peak and subsequent decline in real rates could alleviate US dollar funding pressures, providing significant relief to the negative environment observed in recent months.
In summary, while geopolitical issues continue to influence market sentiment, prompting liquidity tightening—which may be amplified by Q3 financing pressures and external market shocks—the fundamental logic of the current cycle remains unchanged. In the short term, we agree that sufficient attention should be paid to risk scenarios. However, from a medium-term perspective, as long as liquidity conditions eventually accommodate, the investment cycle driven by AI and security themes is set to continue. After the intermission, market strength is expected to diffuse within the security and investment-driven upper segment of the K-shaped recovery. Beyond AI hardware, sectors such as AI applications, industrials, and resource commodities are also poised to begin their second-half rallies.
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