Now Warsh signing in is not a nothing event. So the question everyone asking is wrong… "is Warsh hawkish/dovish", the question should be "are Warsh’s theories accurately priced?". The market has had months to price this transition, anyone acting like this is a fresh catalyst is operating off misinformation.

Before we get into this report, I highly recommend you read these reports below as we have moved directly in lockstep with those views and it relates to this idea that I’m laying out today:

Straight into it, the MOST important thing I’m watching right now is how cross-asset pricing of stagflation has shifted into a reflation style pricing. Now for everyone who is saying, “well oil above $100, hikes priced so equities will probably crash” are forgetting how markets work. Crashes are caused by an asset-liability mismatch that is almost ALWAYS not priced. We’re literally not seeing that, GDP nowcasts across the board are showing how strong growth is despite this energy tail-risk, but not only that, European equity markets have already priced the ECB forward curve.

Now for equity markets to move LOWER (particularly European), there needs to be a FURTHER extreme priced (I’ve spoken about this a bunch of times in previous reports how markets price things VERY fast, they also price extremes). So now we need a tail-wind to FURTHER push European equities lower, which I don’t see as my base case.

Let's say the ECB across the next month double down and basically say they're going to hike 3 times, the markets have already priced that so the markets will just trade the growth data because they want to see if this energy shock has transmitted into any reasonable slowdown.

This is the setup that is causing tail risk to European equities (fully priced in).

And this is how the DAX has responded to that, 6% off ATHs:

Ok so where do I see value? Well there's no doubt that if things don't materialise anywhere in the ECB forward curve (highly unlikely in my view, I don't even think 75bp of hikes will be realised let alone more). I also think that when it comes to this type of shock, growth matters more than anything. So people will get caught up in watching inflation (very important of course), but if that inflation doesn't feed into lower growth then markets can brush it off until inflation is high enough for long enough that it negatively drags growth, then equities will melt down.

But the simple fact is that coming to the market assuming mispricing ALL the time is operating from a place of superiority, which we don't have in markets honestly. Like if you are to assume that your thesis is correct and the market is always mispricing something, then you may get caught offside a lot (I used to struggle with this issue). So instead what I tend to do is have a thesis, look at market pricing and then look at the gap between the two and see if there's actually value to extract between the two, or is my thesis/timing completely off? (you could say both).

I’m also not saying that the market can’t misprice stuff or at least price things that are unrealistic (it can, and does a lot) but to assume that it’s always mispricing a completely different regime all the time is not the way to start.

I like monitoring the risk curve when I hear things surrounding growth crash, recession etc. Do we think that there is some imminent recession or growth crash when the Russell is outperforming ES like this? No. Indices like Russell feel the hit first and by the way, markets price things BEFORE we get data because everyone is ALWAYS nowcasting things. So unless everyone is nowcasting things completely wrong and there is some extreme tail risk we don't know about that isn't priced, it's HIGHLY unlikely we're going to see some type of imminent growth crash or recession, it'd be at least beginning to be priced in my view.

My view is that holding risk being long DAX here makes more sense than being exposed to US equities, I think if the ECB come out today and double down on 75bp, yes it may cause a shakeout but it’s heavily priced, hedges unwind around catalysts and it’s unlikely to push a market down massively considering it’s priced. Remember, energy shocks are almost always seen as transitory if it’s supply led.

Look at every supply-led oil shock in the last 30 years that wasn’t accompanied by a demand collapse, 1990 Gulf, 2011 Libya, even the initial 2022 Russia spike, the equity drawdowns were SHARP but short, 2-3 months max, and then markets re-rated higher once it became clear demand wasn’t breaking. The shocks that actually killed equities (2008, 2020) were demand-led or had a demand-collapse component. So the question I’m asking myself constantly is, is there ANY evidence demand is breaking? PMIs, payrolls, retail sales, credit card spend, none of it is rolling over. Until that changes, this is a supply story and supply stories get faded.

There’s very much the same setup in the UK and it wouldn’t be a silly idea in my view to be exposed either directly to SONIA to trade an unwind in the forwrad curve, or FTSE futures. I just think European equities are a better expression.

There's obviously a tail risk to this. If growth data across the next month meaningfully trades lower (whether that's from energy or not doesn't matter) then I'd expect DAX to start moving lower. If oil trades ABOVE $100 for the next 2 weeks I'll also start getting a little concerned about the timing of my longs because of the Eurozone's energy dependence.

And the reason I'm picking DAX over CAC or Eurostoxx is because the DAX is the most cyclically geared of the European majors, heavy industrials, autos, chemicals, so if the growth data holds up like the nowcasts suggest, DAX gets the biggest beta to that. CAC is more luxury/defensive weighted and FTSE is basically an energy/miners proxy at this point so it trades its own thing. if my thesis is "ECB hawkishness is priced and growth is fine", DAX is the cleanest expression of that, you want the index that's been punished the most on the growth fear and has the most operating leverage if growth data comes in fine.

So to put numbers on it, my line in the sand on DAX is the recent swing low (23,486), if we break that on growth data deterioration (not on an ECB headline, those get bought back) then I'm out and reassessing. On oil, sustained above $100 for 2-3 weeks is my warning, sustained above $110 and I'm cutting regardless of what equities are doing because at that point the Eurozone energy dependence math stops working. Thesis is thesis, but you have to know where you're wrong before you put the trade on otherwise you're just hoping.

Thanks

Alfie

Report:

Video:

Let’s get into Part 2…

The FX Picture

The dollar is the key variable for everything else right now and could be particularly important in 12 months given the implications of a weak currency on the equity market (depending on the extreme of weakness we see in the dollar). I always start with the rates dynamic, but ultimately if structural weakness hits the dollar in the next 12 months (likely) then people will start question, how much of a dollar weakness will equities be able to sustain before a bunch of cross-border selling happens.

I’ve tried simplifying this breakdown, but I’d say if you don’t get it just throw it into AI and ask for help. Focus on the bottom part of this flow chart, that reflexive loop can lead to a type of capitulation in equities. But I’m not trying to fearmonger, it’s just a scenario if we get this structural weakness in 12-18 months time.

So there are different factors driving the dollar in the short run vs the medium run because they point in completely different directions. In the short run, the flows have been driven DIRECTLY by the Iran conflcit which pushed real rates higher and finaly made the USD a safe haven again (which we didn’t see in April). So it’s is a geopolitically driven dollar bid that has LESS to do with the fundamental story.

The medium-term picture is structurally dollar negative. The fundamental logic for continued dollar weakness is: if the Fed is going to cut while other central banks are on hold, the forward rate differential creates outsized downside. There is also MASSIVE fiscal pressures on the dollar as it makes sense to structurally weaken it if Trump is going to be successful at reshoring manufacturing and actually competing with China.

A Fed willing to fight inflation aggressively means that they DIRECTLY keeps real rates high and therefore gives a stronger dollar (which is also a tail-risk to equities eventually), and attracts global capital into dollar-denominated assets and we’ve seen just how sensitive dollar flows are to real rates over the last few weeks. But a Fed that is hopeful about inflation staying above target for longer is a Fed that allows real rates to drift LOWER and adds a bunch of liqudiity to markets, which reduces the carry incentive to hold dollars.

The rolling correlation between real rates and the dollar have been extremely high. It is so important to not just focus on direction of a given asset, you want to see how changes in correlations happen in DIRECT correlation ot the implied volatility of the asset. Don’t let that confuse you either, I am for sure the first one that wants to dumb down ideas. Literally run a rolling correlation and regression model, then watch how changes occur as the imlied vol of the asset moves.

In the most recent video breakdown I spoke about the fact that real rates are the most imortant source of liqudiity because they affect it directly day to day. So when people think about things like QE, yes it’s important, but they only come about in particular macro regimes. I’d rather focus on a liqudiity source that is pulling and pushing liqudiity in and out of the system by the day.

The whole FX market is predominantly just differentials (infl swaps, real rates, growth etc) and the dollar’s strongest fuel is yieldd, but when US yields decline relative to Europe, the UK, or Japan, the dollar forfeits a portion of its carry benefit. That is EXACTLY what the looking through inflation posture delivers.

The euro has been and probably will be the biggest beneficiary because European growth has surprised to the upside and the ECB is no longer in a position where it needs to be dramatically more dovish than the Fed (particularly as they are net importers of oil and would likely need to keep their forward path more hawkish than the Fed).

Equities as a Function of Rates and FX

This was the visual I used in the most recent report, which explains why equities are a function of rates and FX, which is why you can’t run regressions the same. For example, you can ask “what % of movements in rates has accounted for returns in equities”, but you can’t ask “what % movement in equities has accounted for returns in rates” because that doesn’t make sense. Rates don’t move on equities, equities moves on rates and FX.

Equities are a rates and FX story with a fundamental overlay that mostly just determines who wins within the asset class rather than the level of the market itself.

The discount rate is rates. The earnings power of US multinationals is FX. Once you understand those two inputs, you have 80% of the equities story. When the Fed looks through inflation and real rates drift lower, the discount rate falls, which is DIRECTLY positive for valuations. That is the immediate bullish read that equity markets want to run with, BUT it is incomplete analysis because you then need to think about what the FX channel does to earnings and what the dollar’s trajectory means for the composition of returns.

The market level analysis is fairly simple with lower real rates, higher multiples, all else equal. The complication is that all else is NEVER equal. The reason the Fed is looking through inflation is that there is an inflationary shock that is partly supply-driven and partly tariff-driven. That same supply shock that is pushing prices up is also compressing margins for a lot of US corporates, particularly those with significant goods exposure and domestic cost bases that are rising.

So you can have a higher multiple from lower rates and simultaneously have a lower earnings number from the margin compression, and the net effect on price is not obvious.

The FX channel into earnings is the part that most people understand in the abstract but don’t fully work through the math on. The S&P makes roughly 40% of its revenues from outside the US. When the dollar weakens, those non-dollar revenues translate into MORE dollars, which is a direct EPS tailwind. That is the straightforward version of the story, and it is why broad dollar weakness has historically been associated with S&P 500 outperformance. But there is a subtler point which is, a weak dollar also makes US exports more competitive, which benefits certain industrial and tech companies that have meaningful global market share.

The contributons to retruns in the S&P will likely shift meaningfully as we move through the next couple months.

The Sectors That Win in This Liquidity Regime

The liquidity unlocking from a Fed that is NOT hiking is most directly felt in the sectors and asset classes that are most sensitive to the cost of capital. Let’s go through them properly.

Commodities and real assets are the most DIRECT beneficiary of inflation being tolerated above target. If the market believes the Fed is not going to crush inflation, then real assets that act as inflation hedges see structural inflows and you’d probably see XLRE massively outperform (I don’t have an egde on the bottom-up in real estate, but top down would look great).

Real estate is a DIRECT beneficiary because it’s the most explicitly interest rate sensitive sector in the equity market. Mortgage rates follow the 10y more than the Fed funds rate but the signal effect from a more dovish Fed/forward curve does filter through to lower longer-term rates at the margin which improves affordability and cap rates simultaneously.

Small caps are the most interest rate sensitive equity category because they have more floating rate debt relative to large caps and LESS access to the investment grade bond market. When the Fed/forward curve pivots from hawkish to looking through inflation with an eventual cut bias, the cost of capital for small caps falls more than it does for large caps. The Russell has historically outperformed in the 6 to 12 months following the last hike in a cycle. The caveat is that small caps also have MORE domestic revenue concentration, which means they benefit LESS from dollar weakness but are also hurt LESS by dollar strength than multinationals.

Tech (specifically the non-profitable and duration-sensitive end of the spectrum) is the sector that benefits most from lower real rates. Long-duration assets are the MOST leveraged to the discount rate. When real rates fall, the present value of earnings that are 5 or 10 years in the future rises disproportionately. That is exactly why the most speculative parts of the Nasdaq went up so much when rates were at zero and fell so hard when rates rose. The current view I have of real rates drifting lower as the Fed tolerates above target inflation is a positive setup for tech and you’d be best exposed to single names than the sector ETF in my view because some of these moves will be outsized.

I want to just make it clear that by no means am I the guy for EM, I have little edge there as I don’t have many models running on it nor do I spend much time on research there. But emerging markets are the big beneficiary of the dollar weakness that comes alongside this regime.

Portfolio flows into EM equity ETFs are almost ALWAYS associated with a weaker dollar. EM countries and companies often have dollar-denominated debt, so dollar weakness reduces the real burden of that debt. At the same time, EM central banks have more room to cut when the Fed is on hold or cutting because they do not need to maintain rate differentials to defend their currencies. Lower rates in EM, lower debt burdens, a weak dollar supporting commodity prices, and a risk-on environment from easy US financial conditions is a perfect setup for EM.

What’s interesting about EM is that their currency and equity market can often rally together because both are driven by the same thing (dollar weakness attracts capital inflows that simultaneously bid up local assets and local currencies).

I’ve inverted the scale here below, but the Brazilian real has been rallying with their domestic equity market:

The Downside

Now here is where this ALL goes wrong. The most dangerous scenario is the one where the Fed’s tolerance of above-target inflation is read by the market as a structural shift in the reaction function (policy error).

Right now, long-end inflation swaps are still anchored around 2% which suggests the market believes the Fed’s long-run commitment. But that anchoring is a belief, and beliefs can change quickly when data changes. If business-level inflation expectation starts to become entrenched, you get second-round effects that make the energy shock look LESS transitory than the Fed is modeling.

The second downside is what happens if the labour market breaks more than the Fed expects. The Fed is looking through inflation partly because they believe the labour market is just cooling rather dramatically cracking. Just look at how volatile jobs growth has been:

The Fed’s March statement pointed to reduced hiring rather than widespread layoffs as the dominant dynamic. If that characterisation is wrong and you get a genuine labour market deterioration, the Fed faces a stagflationary dilemma where cutting would add fuel to the inflation problem but not cutting would accelerate the labour market decline (1970s type analogue), but I really don’t believe we’re heading there. You can see how there has been a little more emphasis on the jobs data:

The third downside is positioning. If the consensus trade is long risk, long EM, short dollar, short rates vol, and that positioning is crowded, then any shock that forces a reversal of those positions becomes amplified beyond what the fundamental catalyst would usually warrant.

The backdrop of record high markets combined with rising underlying implied volatility has created a distorted risk profile where catalysts are likely to trigger larger than normal market movements. The size of the reversal from a crowded consensus unwind can be severe particularly if carry trades start to unwind.

Why Sustained Dollar Weakness Can Actually Hurt Equities

Firstly I’d say refer back to the first flow chart in this report. This is the part that most people miss and it is worth really thinking through carefully because cross-border flows matter so much.

There is a version of dollar weakness that is good for equities (which is why we often see inverse correlations between equities and the dollar). That is the version where the dollar weakens because global growth is accelerating, the rest of the world is growing faster than the US, and capital is rotating into higher return opportunities abroad. It’s basically the dollar decline that comes alongside a global risk-on environment. Multinationals get the earnings tailwind from translation, and EM gets the capital inflow and everyone wins.

The equity-negative version is where the dollar weakens because of concerns about US fiscal credibility, because foreign holders of US assets are reducing their exposure, or because the Fed’s willingness to let inflation run above target is eroding confidence in dollar-denominated assets as a store of value (this is the likely trigger in this scenario). In this version, you get a situation similar to 2022 in reverse, where a falling dollar is associated with falling US equity prices because both are symptoms of the same loss of confidence in US financial assets. There’s been much more positive stock-currency correlation across the last 5 years than there were in the previous 5 before that.

It’s not always obvious in real time which version of stock-currency correlation you are in (fiscal credibility or Fed behind the curve) but this is why it’s SO important to run rolling regressions and attributions so that you can see where flows of capital are going. The signal to watch is the relationship between stocks, bonds and the dollar rather than in pairs.

In the less worrying version, all three can do reasonably well because the driver is global growth optimism. In the toxic version, bonds sell off, the dollar sells off, and equities sell off together because the driver is a loss of confidence in US assets broadly. A significant widening of swap spreads (which is just where Treasuries trade higher in yield relative to SOFR rates) and sustained steepening of the 2s10s would be signals that the selling of bonds is becoming an issue beyond normal cyclical dynamics.

The more practical channel through which sustained dollar weakness hurts equities is through imported inflation. If the dollar fallsaggressively on a trade-weighted basis, it adds somewhere between 50 and 100bp (historical avg) to domestic inflation through import prices over a 12 to 18 month lag. For a Fed that is already tolerating above target inflation, that is a MASSIVE problem because it extends the period during which they cannot cut even if growth is slowing. You end up with a tighter for longer outcome by the back door even though the Fed never explicitly tightened. That slower growth, higher inflation, constrained Fed combination is NOT the environment that justifies the multiple expansion that equity bulls are counting on.

The bottom line across all of this is that the regime of the Fed tolerating above target inflation is fundamentally a bet that the transitory story is correct and that the second-round effects do not materialise. If that bet pays off, you get lower real rates, a softer dollar, higher risk asset valuations, strong EM performance, and a steeper curve that reflects growth optimism rather than credibility concerns.

If it DOESN’T pay off, you are in the scenario where the central bank falls behind the curve, loses credibility, faces a dollar that is falling for the wrong reasons, and an equity market that eventually reprices to reflect the reality that easy financial conditions were built on a foundation that turned out not to hold.

Thanks

Alfie

Below is the full video breakdown of my most recent report.

Report:

Video:

Thanks

Alfie

Firstly, when quantifying these changes and trying to find the most likely transmission channel, the part you want to focus on first is rates, then FX, then equities because equities are just a function of what rates and FX are doing:

So I want to begin with a scenario about what could actually happening here. The Fed is sitting with rates at 3.75% with short-term inflation swaps running above target and energy prices being pushed around by the Middle East. There is more risk of persistent above-target inflation throughout 2026 and yet the forward curve is beginning to shift back towards pricing a probability of cuts this year which will likely get more aggressive in repricing as we progress through this cross-asset implied vol/geopolitical premium unwind.

The Fed are going to likely make a conscious decision that the one-off nature of the price-level shock from energy does NOT warrant a policy response because that would likely crush the labour market, and real consumer spending definitely isn’t at levels that would survive hikes in my view.

See my recent video breakdown on this idea below:

The Dec26 contract has a bunch of vol running through it, you can see this in the open interest if you go to the CME website. So if you’re trading the forward curve directly you want to be most exposed to Dec26-Mar27 in my view. It was only last month we had the terminal rate sitting in the Sep27 contract, and in my view I think it probably stays there because even if we get repricing of the curve (likely), I think it’s unlikely that the terminal is brought forward because that’d be a little extreme considering the backdrop (if they’re going to cut into inflation, they’ll do it slowly). So I think we’re likely to see a shift in the terminal rate from Z7 to U7 at best.

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Capital Flows

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3 years ago · 651 likes · 19 comments · Capital Flows

What It Does to Rates

Start with the front-end because that is where the Fed actually has control. If the committee is on hold but leaning toward one cut, then 2y rates are basically anchored in a range. It can’t rally dramatically because the Fed is not hiking, and it can’t sell off hard because the repricing of rate expecttaions isn’t front-loaded and hasn’t been that aggressive YET. I think given the setup with real consumer spending and job market growth, it is HIGHLY unlikely that we see 2y rates rally above 4.1%.

The direct implication of inflation being seen as a one-off shock is that the 2y has a ceiling, but this is likely to set us up for a higher normalised range in the 2y when the liqudiity in the system becomes unsustainable and the Fed are FORCED to hike into whatever backdrop they’re dealing with.

Of course the Fed has made it clear that they need meaningful confidence that inflation is moving lower in a lasting way before acting. So what you get in 2y rates is a tight range where it’s pinned by the forces of the forward curve but also higher realised inflation/lliqudiity in the system. Rates in this type of regime would be the most sensitive to data surprises rather than any directional repricing of the policy path vs equities or the dollar.

The long end is a completely different conversation. 10y rates are NOT set by the Fed. They are set by growth expectations, inflation expectations, term premium, and increasingly by the foreign bid for US assets (cross border flows). So when the Fed looks through inflation, what the bond market hears is that real rates are going to be held below where a strict inflation fighting mandate would put them. It’s still a very different picture to 2022, but the risks are that the Fed starts falling behind the curve and pinning real rates WAY lower than they should.

I think the 10y could be structurally pinned higher than the 2y which is why I expect to see a bunch of steepening in the 2s10s.

If the market decides the Fed is making a policy mistake, term premium starts to rise which is why I said that I think the 10y will be structurally pinned higher than the 2y. You can get a situation where the nominal yield is actually going up even as rate expectations drift lower because the inflation compensation demanded by bondholders is expanding, basically more duration risk starts being hedged.

The more interesting 2s10s steepening I’m watching for is the bearish kind, where the front-end is held by policy but 10y rates rally because the market is questioning whether the Fed’s dovish lean is going to structurally undermine the inflation anchor. There’s a strong case that the Fed falls way behind the curve by the time we move into 2027, and I’m spending time thinking about the implications of that but most of all, the direct beneficaries.

Bear steepening is NOT friendly for equities. It’s the rates regime where you get rising long rates that are signaling credibility concerns, which is a COMPLETELY different transmission mechanism than what most equity investors are pricing in. ES struggles in most 2s10s bear flattening regimes:

The setup in inflation swaps is interesting because the 5-10y swaps (which is the market’s cleanest read on long-run inflation expectations), have remained broadly consistent with heading towards the 2% target. So the market is not yet calling the Fed’s credibility into question at the long horizon, there is just simply a tail-risk scenario which involves the Fed looking through inflation (if it transmits into core, which could be lagged… and they may have already cut by then).

It is only near-term inflation swaps that have moved, which tells me the market believes the transitory story but is hedging against the risk that it’s not.

There is not as much of a fade trade in SOFR as there was a couple weeks ago, unless you believe the Fed is going to be materially more dovish than advertised (which would require a labour market deterioration that is not in the current data).

Job gains have remained low across the last few months (bar the recent release), and the unemployment rate has been little changed in recent months, which looks more like reduced hiring vs outright widespread layoffs, but we could definitely see that theme a companies cut back on nonsense roles and literally just set up an AI agent to replace them.

The data that begins to matter more as a trader when the Fed is looking through inflation is not what most people think. Of course everyone fixates on CPI and PCE, and yes they matter, but they are lagging indicators in this regime. What you actually need to watch is inflation swaps across the curve to see how the market thinks about longer-term inflation.

Right alongside that, unit labour costs and average hourly earnings becomes MASSIVE because wage growth is the mechanism through which a supply-side price shock becomes embedded in the cost structure of the economy and turns into genuine second-round inflation. If wages become hot, then the transitory idea isn’t valid.

When households start expecting higher prices, they start demanding higher wages and bringing forward purchases, which is self-fulfilling in a way that market breakevens are not.

The Volatility Complex and How It Transmits

Rates volatility is the parent asset class for everything else. When implied vol in bonds is elevated, it means there is real uncertainty about where short and long rates are going. That uncertainty does NOT stay in the bond market. It bleeds into FX implied vols, which bleed into equity implied vols, which ultimately determine how risk assets are priced across the whole spectrum (look at the visual at the top of the report on this connection: rates > FX > equities). Rates are the heart of ALL markets in my view, equities are just a function of what rates and FX are doing.

I actually made a point in a previous report, before this blow out in cross-asset vol, that there were tensions underneath the surface across the rates curve that gave rates and the dollar massive upside:

See the report here for context:

When rates vol is high, the cost of hedging interest rate exposure goes up (plus the rates market is the largest market for hedging risk). So then that makes it more expensive for corporates to hedge their debt, more expensive for banks to run duration, and more expensive for systematic strategies that use vol as an input to their position sizing to hold risk.

Basically, when the cost of hedging goes up, exposure gets trimmed across the board, and that means lower equilibrium prices for risk assets regardless of the underlying fundamental story (which is why we actually see the S&P hold up well considering the risks, because underlying fundamentals are strong but the macro backdrop was the drag).

Equities don’t like bond vol:

When the hiking cycle was live, every CPI print was a potential catalyst for a repricing of the policy path, and that is what kept bond vol elevated relative to historical norms. So if the Fed stay on hold near-term and begin to cut through the next 6 months, the directional uncertainty in the short end collapses.

On the other hand, if the market starts to question the credibility of looking through inflation, you get long-end vol picking up even as front-end vol stays contained (the idea above), and we’d see MASSIVE steepening in the 2s10s.

The transmission from rates vol into FX vol is very reflexive. When you don’t know where US rates are going, you don’t know what the carry differential between the dollar and every other currency is going to be. So that uncertainty means FX options are more expensive. More expensive FX options mean it costs more to run open cross-border positions, which deters capital flows at the margin and can create the kind of choppy, two way price action that you have been seeing in majors this year.

The transmission from FX vol into equity vol is slightly less reflexive. When currencies are moving aggressively, the earnings uncertainty for multinationals with significant non-dollar revenues or costs expands MASSIVELY. A big unexpected move in EURUSD or USDJPY in a quarter can swing EPS outcomes by hundreds of basis points for large cap exporters. That earnings uncertainty gets priced into equity implied vol, and elevated equity vol suppresses valuations through the discount rate and risk premium channels simultaneously.

The casual chain is: Rates > FX > Equities. Equities are simply a function of the state of the rates and FX market. There will be a part 2 on this idea where I’ll be covering the implications of this idea on FX and equities, but sectors in particular.

This is a visual on the implications:

Thanks

Alfie

Thanks

Alfie

The recent real GDP print sparked growth fears/recession talk, but the headline figure is distorted by transitory composition effects. Strip out the government and trade distortions and the private sector is in reasonable shape. Consumers are STILL spending, business investment in tech and equipment is holding up, and forward-looking demand indicators across both services and manufacturing are pointing higher (you’d be seeing these roll over with momentum if there was some sort of growth shock was on the way). The economy is not running hot by any means, but it is also NOT breaking into stagflation.

The Fed is effectively stuck at the minute but this could quickly change before their April meeting. They’re unable to cut because of this inflationary tail-risk from oil, and unwilling to hike (in my view anyway) because the labor market and growth inputs are sufficiently not powerful enough to survive hikes. The markets are pricing hikes but this is still blown out of proportion in my view. As QUICK as markets can price hikes is just as QUICK as they can price them out.

This is where the 2022 comparison completely breaks down. In 2022 the Fed was MASSIVELY behind the curve. Real rates were deeply negative, financial conditions were extraordinarily loose, and the Fed was STILL buying assets while inflation was running at 8%. The tightening cycle started from a position of maximum stimulus into maximum overheating. We have NOT got this starting point.

Today rates are ALREADY meaningfully restrictive. The Fed is NOT behind the curve on inflation in any comparable sense (you could say they’re behind, but relative comparison it’s nothing like it was). They are sitting with rates above neutral with inflation above target. The question is whether they can ease at all, and the answer is probably not YET, which has been reflected in the forward curve.

The Fed being forced to hold rates is NOT the same as emergency tightening, and conflating the two leads to the wrong conclusions about asset pricing.

I’m running some models on a terminal, iterating them as fast as I can to push out as much value to you guys as possible. My regime quadrant falls into this stagflaiton box but VERY close to reflation, it was tilted by the oil shock and the lack on confirmation of from both sides about a de-escalation, meaning oil stays in this higher range for longer, but this is just a regime model and NOT something I’d set a thesis on, but it’s definitely accurate in the fact that it’s still on the edge of reflation.

Considering that the US are in a full battle with Iran AND the market is pricing stagflation, ES is only 7% off ATHs. Now, given regime-expected returns for stagflation, repricing of the forward curve AND a war with Iran, I think the index is holding up fairly well and reflects supportive growth in the underlying economy, which once again supports us moving into a reflationary regime.

Regime expected returns:

There’s still a LOT of tension underneath the surface in equities (I laid this out in the previous report, check it out). Implied vol is still at an extreme and it only takes ONE confirmation to unwind this all, we’ve seen how reactive equities are on these types of headlines, we had ES move well over 3% wihtin 5 mins on a headline about Trump saying there was an agreement being spoken about/talks were happening (whether true or not).

The moves have mean reverted but when there is somehting official from both sides, you’d expect to see the same outsized moves as hedges unwind and this implied vol moves lower meaningfully, it’d be a cross-asset compression of vol in my view.

Another input that makes the current setup push toward reflationary rather than continued stagflationary is the demand component. Stagflation requires growth to be actively deteriorating while inflation rises. The leading demand indicators, forward orders in both manufacturing and services, are NOT suggesting deterioration.

If that resilience is confirmed over the next couple of months, you have an economy running at trend with inflation ticking higher on the energy transmission. Nominal growth reaccelerates modestly even as real growth stays moderate.

The current read across stocks, bonds, and the dollar shares surface similarities with 2022, with equities down, bonds down, and the dollar up. But the regime underneath is ENTIRELY different. The most common regime following stocks down, bonds down and dollar up is actually reflation, which would be much more aggressive vs 2022 as the underlying growth and liquidity in the system is NOT supportive of prolonged stagflation in my view.

A lot of the tension underneath the surface in the current equities setup is also pinned by the forward curve, which looks very unreasonable to me. It is beginning to price about a 50% chance of a hike this year. But this is all on the assumption that the current state of the market remains throughout the next 2 months at least, and we have seen the opposite of that with less attacks and more signs of wanting talks and de-escalation. It’s also common knowledge for central banks to look through energy shocks while monitoring tail-risks.

The instinct to reach for 2022 as the reference frame is understandable because you have inflation above target, a Fed that CANNOT cut with ease, and a growth picture that is muddled enough to make people nervous (particularly through the labor component). BUT, the inflation that persists is not the violent broad-based surge of 2022.

If the war prmeium gets unwound across all assets, which has evident signs of being a potential (as I mentioned above, negotiations are being mentioned), then we go back to focusing on the transmission of thse oil prices into the economy, which is still a very different story to 2022…

What that means for risk assets is also different from 2022. In that year the valuation reset was brutal because assets had been priced for near zero rates, and the duration hit to equities, bonds, and growth assets was violent because the starting multiple was so stretched.

Today valuations are not cheap by any means, but they are also NOT priced for a zero rate world either. The market has already adjusted to a higher for longer framework in its baseline. Rotation still matters A LOT here.

In 2022, there were also MANY more shocks to posotioning. The shocks we’ve seen through the last 12 months have all been geopolticial shocks (particularly through Trump), which is a complete different tail-risk to a direct inflationary shock.

Today the market is ALREADY sensitised to inflation risk. The narrative of sticky inflation, higher-for-longer rates, and Fed paralysis is consensus and definitely NOT a contrarian call. That changes the dynamics of how the regime unfolds. In 2022 every inflation print was a fresh shock forcing incremental repricing. In 2026 a reflationary regime would be a confirmation of something already partially priced, which means the moves are likely to be more gradual and more sector specific than the brutal across the board de-rating of four years ago.

I still remain with the view that I want to get short USD and long equities.

This is NOT 2022 repeat. This is a different animal entirely, and trading it like the last cycle will leave you positioned for the wrong risks at the wrong time.

Thanks

Alfie

The ongoing war

I think the most interesting part about the position equities, rates & FX are in right now is the fact that even as we get headlines and progressions on tensions BUILDING (e.g. more strikes on embassys etc), we’re having less of a downside in equities, less of an upside in rates and less of an upside in the dollar, it just shows me that we’re at an extreme in price and for any leg lower there’d need to be even more of an extreme that isn’t yet priced (e.g. other countries involved heavily, heavily more attacks etc).

For example, these types of headlines below were creating outsized moves in the first few days of the war, but like anything, the market begins moving to an extreme and pricing the most extreme scenario.

I like monitoring the reaction and cross asset correlations as we trade through these headlines/events/catalysts because it gives you an idea of exactly what is being priced. The last thing you want to start doing is taking bets on what’s already priced (e.g., if you’re going to bet on a continuation of this US-Iran war, you could probably be flushed out UNLESS there’s an extreme because we’ve already priced this)

This was the headline:

Oil, which has been the main component that has caused outsized moves in equities, rates & FX, now looks to have created a top in implied vol as skew is rolling over. If oil continues to trade at these extremes as vol drops significantly, its the market accepting this price as the new reality for oil but what is key to watch is that if a de-escalation happens (likely in my view), then there will be outsized moves in oil relative to other markets.

Edge is most found when you see dislocations in correlations, right now we've seen implied vol move in lockstep with oil, but as implied vol has ticked down we haven't seen oil prices move lower to the same degree (dislocation). Basically, if you take the other side of this dislocation (e.g. being short oil), then the move lower will be asymmetric IF oil re-correlates with implied vol. I'm also not saying its time to be short oil, I don't necessarily have an edge there but I definitely WOULDN'T be long.

I think if oil stays above $90 as implied vol and skew normalises without any breaks, I’d be worried because that means oil is trading on markets implied pricing rather than a geopolitical premium. Same for equities, if we start seeing vol drop massively and a de-escalation in the war with no meaningful upside, I’d definitely be closing the long exposure I have (which is in NQ right now, also laid that out in those previous reports tagged at the top).

By no means would I ever base a thesis on historical data, I think that’s a massive limiting factor and doesn’t provide any context, but I think its very interesting that when you run a historical test on the S&P price action in the following 1D, 5D, 1W and 1M after conflicts, has been an extremely positive outcome. Initial reaction is mixed: 6/10 conflicts positive 1D (avg 0.22%). But the 1m outcome is historically constructive: 9/10 positive (avg 4.29%). It seems like markets tend to look through geopolitical noise within 3-4 weeks. The only caveat was the Soleimani 2M (-8.68%) is distorted by COVID-19 rather than the strike.

It’d be unwise to assume that there isn’t also moving parts UNDERNEATH the surface of this war. Moving parts as in, the US gaining leverage to global partners, think just how Trump used tariffs as a direct negotiation tool, this is more indirect and he understands the power the US can hold by proxy in this US-Iran war. Do I think he’s bombing Iran ONLY for the sake of these underlying power gains? No, but it sure plays a part.

I’d say it’s the most significant leverage plays the US has had over China in years (tariffs were tit for tat, China can’t respond here). Hormuz carries roughly 20% of global oil supply and with it effectively closed right now, China, the world’s biggest oil importer, is taking a SERIOUS economic hit. The US doesn’t have that problem, it’s mostly energy independent and absorbs this far better than Beijing can.

What people are missing is that Iran was one of China’s most important non-Western partners. The US has essentially neutralised one of Beijing’s most important geopolitical functions in the region. We also must remember there is a lot that goes UNSEEN. Just because Trump is explicit in his actions, doesn’t mean that there isn’t deals/negotiations going on behind closed doors, I seriously do think there’s some type of deal he could be trying to strike with China during this time, especially when China’s growth has been DOWNGRADED as a direct result of the war.

Whether you think that’s justified or not, Beijing is watching VERY closely, especially with Taiwan always in the background. China simply cannot afford to test the US right now while it is in a hot war and clearly willing to act. Trump even pushed back the Xi meeting because of the conflict, which is a pretty clear signal that China’s cooperation is something the US expects. Every week this drags on is another week of economic pain for an economy that was already under pressure domestically, with Gulf shipping disrupted and China’s export chains running right through that region.

It also seems pretty consistent that the dollar actually weakens after these types of conflicts (once again, I’d NOT recommend using history as your sole thesis)

Why does that matter? If the Trump administration can directly make the USD weaker, they are gaining another advantage in the power play of exports against China (making exports cheaper so gaining some leverage over China).

FOMC

Now there’s two catalysts that can DIRECTLY unwind positioning in FX, rates and equities which is now what I’m shifting my focus on. Which is 1) news about a de-escalation/the war is over from US/Israel/Iran with a potential deal between them. 2) the FOMC meeting today. Now the outcome is already SEEN and known for the meeting, we’re likely to get a pause and that’s not where my focus is given the pricing. If I’m currently taking the other side of market pricing (e.g. I’m long NQ as geopolitical issues are apparent), then I want to see the Fed’s stance also take the other side of market pricing.. but what does that look like?

If Powell comes out and identifies this spike in oil as transitory and that he is not worried, there could be massive shifts in positioning and the function that begins this would be in rates as the curve likely reprices in 10-15bp+ initially and adds as the weeks go on.

The reason I like this view as being the one that unwinds positioning is because I think even if Powell comes out saying that the rise in oil prices could transmit into the economy and that inflationary pressures are a massive worry…. I don’t think that shifts much in rates (and therefore equities and FX), simply because I believe this extreme is already priced. Now the only rhetoric that would swing rates higher, equities lower and the dollar another leg higher would be if Powell comes out so aggressively saying they expect hikes this year, maybe mentions their base case is 1-2 hikes this year.. but I mean, how likely is that scenario? Very unlikely, I’m happy to take the other side of that given the extreme of the forward curve right now:

The reason I say this is unlikely because what sense would it make to hike or keep rates here for the rest of the year given the slowdown we’ve seen in the labor market, considering that there’s a likely probability that oil prices unwind (based upon de-escalation and Trump’s goal to drive oil prices lower). So in my view, IF the FOMC speech is going to be a catalyst for equities to go higher and rates to go lower, Powell would likely need to signal the fact that oil prices are transitory.

People will probably say that the base case is for Powell to sit on the fence and say this could transmit etc, but that still wouldn’t cause downside in equities, and if it doesn’t cause downside in equities then implied vol will probably unwind as hedges close, so that makes it implicitly bullish equities. If he takes the other stance and says oil could transmit into inflation, that still doesn’t give the hawks a new catalyst, and if there’s no new catalyst for downside = vol unwinds = implicitly bullish equities. The bar to be more bearish than current positioning is already extremely high.

The unwind is already partially being seen in US equities, but I think it could unwind WAY faster. If there were some type of imminent threat or major escalation that everyone was hedging for, NQ wouldn’t be outperforming the S&P on an outright basis across the last 5 trading days. As usual, if an extreme is priced, we now need to be SHOCKED for markets to even move. A shock in this instance can come from two inputs discussed above, yet both are highly unlikely.

So on the assumption that the war is at its extreme (not saying it is, just laying a thesis), then the focus shifts back to the domestic setup, which has mostly been centred on growth, which in my view is not in a position where we're going to see a massive downturn/recession (all these ideas suporting a recession are blown way out of proportion given that everyone is ONLY focusing on NFP). I'm not discounting the importance of NFP but I will say that the economy can likely operate effectively and grow even without massive amounts of jobs being added, so until we see noticeable shifts in real consumer spending, I'm really not worried about growth here and I think it's likely that the Fed cuts twice this year, and we will start normalising in NFP figures (or at least stop this level of slowdown).

The most likely curve regime we'd see if we were heading into a recession or growth scare would be bull steepening as credit spreads would be compressing directly in line with lower growth prints, which is NOT happening. The only compression we're seeing in credit spreads is directly from breakevens/the tail-risk to inflation through the energy component. That means if there is de-escalation (and oil starts moving lower), then breakevens will likely start ticking DOWN and credit spreads tighten with momentum, which will give upside to equities as credit spreads is one input into the equity return picture (NOT the full picture).

Thanks

Alfie

Posted about this on X. The core idea is simple.. find the underlying drivers of FX, equities and rates, then tie them to what catalysts could confirm or shift the view. If everything is currently tethered to geopolitics, a CPI print is noise. The upside macro foundations are blocked by oil-driven rate repricing until war clarity emerges.

See my recent report on the macro regime as I am building on these ideas:

The question worth asking is, what if the oil shock ISN’T transient? If oil stays elevated for 6+ months, the Fed's reaction function potentially stops cuts, or pushes terminal rate expectations even further out (both highly unlikely, but possible).

That’s the scenario the market is beginning to price. And it’s the scenario that’s driving every cross-asset move you’re seeing right now.

Even with labor continuing to soften, growth, inflation and liquidity are sitting in a place that structurally gives upside in equities, downside in the dollar, and ranged bond price action (upside at best). Duration risk is the only reason I wouldn’t say bonds are firmly skewed higher from here.

What matters for getting long the index is whether the underlying drivers unwind or persist, and that depends entirely on the correlation structure. If the driver is war > oil prices > equity vol, in that order, then everything is directly connected to how the war develops. Right now we’re seeing bonds move in lockstep with equities, both lower. That matters, because it CONFIRMS this move is macro-driven. This is the reflation story driven DIRECTLY by the rise in oil prices.

To be long the index, I want to see a break in the bonds/equities lockstep lower. Right now it’s confirming oil-rate transmission dominance. I want to see equities outperform bonds on cross-sectional momentum.

Just another key note.. if this were a growth shock, we would NOT be seeing NQ outperform ES on a 10d lookback. NQ is arguably the most sensitive index to inflationary pressures and Fed repricing. If growth were that much of an issue, and this inflationary tail risk persists, we would be seeing ES > NQ > RTY leadership in that order, with all indexes returning massively negative over the past two weeks, but we're not seeing that.

Bonds and equities moving together confirms it's a rate repricing event sourced from oil (which is sourced from geopolitics). So the question becomes: if oil/war is the single function controlling rates, and rates are the mechanism transmitting through to equities, what do I need to see to get long the index when the macro regime is otherwise supportive?

Firstly, oil needs to form a top in both skew and implied vol. That's the direct function controlling rates moves, which is transmitting through to FX and equities. For every tick higher in oil vol and upside skew, we've seen downside pressure in bonds and equities as the dollar trades higher on STIR repricing. Long entry in the index requires oil stabilisation confirming reflation peak, oil staying below $80, and a decline in both front-end rate vol and crude futures vol. The correlation intensity between those two (front-end & crude vol) is what confirms transmission persistence.

Oil headlines now have MORE sensitivity to rates than they did two weeks ago. The OPEC+ production decision Sunday is partly in my focus. A production increase shows a supply response to the war premium, then crude falls marginally and lowers the impact of the inflation transmission chain. But the danger is that they release more supply in response to the war, the war premium gets added straight back a day or so later, and whatever OPEC just did is immediately mitigated.

Duration sensitivity magnifies the rate lockstep we're seeing, but positive growth and liquidity conditions are the offset, if oil lets them breathe. If NQ begins to outperform ES, that's evidence the market is starting to look past duration sensitivity and the oil transmission story (we’re already seeing this).

The front-end is anchored by softening labor. The oil spike forces hawkish repricing risk in near-dated cuts, which is why the range will likely persist until war and oil resolve the inflation transmission path. ZF has the highest risk/reward once (and if) the war fades before growth deteriorates further, in my view. The belly could reflect labor softening while avoiding duration risk, especially if the oil repricing is already reflected in the curve by then. I'm not in that trade yet. I have no informational edge on geopolitical timing, and I won't front-run it.

The dollar has moved in lockstep with the blowout in oil prices. The first thing I want to see break when the index bottoms is the dollar-oil positive relationship fracture. I want to see both trade lower, but with the oil move carrying more momentum than the dollar. Equal magnitude dollar weakness isn't that posiitve for equities in my view. An outsized dollar selloff is actually a risk, foreign capital repatriation at pace would send the index lower (I also don’t think this is likely, but possible if the dollar moves lower at speed). The structural disinflation story should overwhelm the transient energy shock bid in time, if geopolitical issues wrap up soon.

Another KEY show of hand will be if/when SOFR reprices. Front-end rates normalise back toward the cuts that were priced in Dec 26 prior to this blowout (around 60bp, the 2-3 cuts range). Terminal rate has moved to Z7, I want to see it backtrack toward the June-Sept 27 range to show real normalisation.

I hate to be a central bank speech watcher.. BUT Fed speech that dismisses the oil spike as transient while emphasising labor softening could be a catalyst to reprice SOFR. It likely creates a bottom in the forward curves, likely a top in the dollar, and firms the picture for being long the index (if war and oil prices have also deescalated to the point where implied vol in both drops).

We’re not in a regime where the Fed has direct control over where rates land (in my view), I think the market has forced their hand repeatedly across the last 6-12 months. Even knowing the equity blowout is war-driven, the repricing of the forward curve has direct valuation impact on equities, so Fed communication is a co-catalyst.

One more thing to anyone fearmongering a recession, the labor market can soften without a recession. There’s a plausible scenario where the Fed cuts enough to stabilise labor while US growth continues to outperform the RoW. That remains in the mix.

I also mentioned how if we see curve steepening, I think that gives upside in equities only if the energy component is fading. If the long end sells off because duration risk continues to increase on inflation uncertainty, the picture is more ambiguous. Mild, equities can shrug it off. Aggressive, the discount rate on future earnings rises, you get multiple compression, and the long thesis weakens.

The steepening I want to see is bull steepening, front end falling on repriced Fed expectations. But if labor continues to deteriorate simultaneously and credit spreads widen, even bull steepening doesn't give you clean upside in equities.

My base case is still that the transient oil shock fades, SOFR reprices at least 60bp into the Dec 26 contract, and the curve bull steepens.

Thanks all!

So there’s emphasis on jobs data but there is no direct labor risk risk being expressed in bonds, FX or equities, all of this movement is driven directly by the US-Iran tensions.
Jobs data no doubt has a transmission effect from consumer spending, all the way through to corporate revenue, but we're simply not there yet. Given the interest rates the US has seen across the last 2 years, its a given that jobs data has direct pressures like this. If there were an immediate growth risk, we would not be seeing positive 3m & 6m annualised speeds across most growth metrics as rate cuts get priced out in my view (which will likely unwind). I’d say that the jobs data we're getting is important but the transmission won’t be immediate, we certainly wouldn’t be seeing corporate earnings smash estimates if growth was CURRENTLY an issue.

We're seeing MAJOR tail-risks with the US-Iran war right now as oil traded through $100 this morning, yet equities are 4.3% off ATHs (as I type). I believe that any fast slowdown in growth will be an existential risk (like major negative developments with this war) rather than any domestic action inside the US that sends them into a recession, it’s simply not a base case for me.

Equity vol has blown out in massive proportion and in my view, equities themselves haven’t reacted to the same degree. What I think the likely scenario is, is that as equity implied vol unwinds, then we will see an outsized move to the upside across EVERY sector. Why do i think this? Well, for every tick higher we have been getting in equity implied vol, the index fails to move lower to the same degree. When you run a historical test on this, you’ll be able to see how much the index typically moves for every 1 unit higher in vol (I will share this once the dashboard is debugged), we have seen LESS of a move lower in the index for every tick unit higher in vol which means there is a higher sensitivity to the UPSIDE in equities for every unit LOWER in equity vol.

Rates are the control point. They are being driven heavily by inflation directly through the energy component, which can be unwound VERY fast in comparison to if the inflation component was being driven by something like services, which isn’t the case here. I’m monitoring the sensitivity rates have to oil in particular and have a few models running which will show me when a decorrelation occurs, then the rates regime moves away from inflation driving the market through the energy input. But I don’t expect to see that across the next week or two, not at least until oil creates a top and SOFR creates a bottom.

What's key to watch is that we've been sitting in this negative returns, high implied vol regime where there is LESS upside given such a premium in vol. When we begin to see this unwind on a 5d lookback (positive returns, lower vol), we'll have likely created a bottom and heading towards another leg higher in my view.

Now inflation risk is larger than growth risk (coming directly from energy), so the energy component is the direct source that will determine the next regime we step into. It is likely that for as long as oil fails to create meaningful pressures to the downside, a case for stagflation persists and the 2s10s is evidence that inflation risk is larger than growth risk as the curve bear flattens on repricing in SOFR.

BUT.. 2s10s has a negative RoC but at a diminishing pace so if we begin to see steepening in the curve as cuts start getting repriced in (likely), then ultimately I'll be more sure that we're not heading into any imminent slowdown. What I DON’T expect is sustained bear flattening acceleration, that would completely invalidate the oil-driven inflation peak thesis, and if the long-end sells off despite a front-end rally, that breaks the steepening narrative entirely through either breakeven deanchoring or fiscal concerns.

So the sequence I'm watching plays out like this. Oil creates a meaningful top and moves through sub-$80 and the energy-driven inflation component unwinds rapidly. SOFR repricing accelerates, front-end treasuries rally hard, ZT bids aggressively as 50bp+ cuts get priced back in. 2s10s steepening then resumes as the bear flattening exhausts itself, which confirms the regime shift. Real rates decline as cuts reprice faster than inflation unwinds, and that real rate compression is what supports risk assets. 5Y and 10Y breakevens compress as the energy disinflation dominates, though they'll lag spot oil a bit because services stickiness is still there in the background, if services stays sticky above 0.4% MoM then breakevens don’t compress the way the thesis needs.

On equities, if the war was still causing major downside, what we WOULDN’T be seeing is tech up and leading on the day as equity vol unwinds and NQ outperforms ES. This type of rotation is evidence that there is more sensitivity to the upside in equities when equity vol unwinds in comparison to any more premium being added to equity vol causing downside. NQ outperforming ES on vol unwind days, and the fact that the NQ/ES spread correlates directly to VIX collapse, tells you everything (tech duration sensitivity and vol unwind are moving in lockstep).
For this exact reason, and with the assumption that oil starts moving below $80 through the next 3-4 weeks with some momentum, I think we’ll see SOFR create a floor here and MORE cuts start being priced for the year. My base case is 50bp, but this is dependent on the energy component and just how fast oil rolls over, could push up to 75bp is NFP continues to print lower as the energy component becomes LESS of a risk.

The KEY RISK to all of this is if oil sustains above $100. If that happens, the energy inflation component persists, SOFR repricing stalls, and were stuck in this single-driver regime tied to the war premium indefinitely. The other invalidation I'd be watching closely is if equity vol starts rising while indices fall IN LINE with it, then that breaks the asymmetric sensitivity relationship and tells you the downside accelerates from here rather than the upside. Same with growth components, if 3m/6m growth speeds turn negative then the no-growth-crisis framework is dead.

Macro sensitivity is rising and the market is being driven by ONE input, war, or even Trump if you want to say that, because he is the ultimate driver of this war. Near term I’m watching CPI on March 11 for the energy component deceleration, FOMC March 19 for any dovish dots shift from the Fed transition, and retail sales March 14 to validate the jobs-to-spending lag thesis. When we begin to see oil roll and rates lead the way as ZT bids higher on repricing cuts BACK in, it’s likely going to be the best time to get long the index, particularly NQ. Monitor skew & implied vol through sessions and run analysis on the sensitivity to each side to build a picture of where the most tension is being held in markets and where the largest unwind is likely to happen, which, in my view, is to the UPSIDE in equities.

The thing about these market drivers (the war right now for example) is that when they blow over, everyone forgets. Literally just last year when it came to June everyone wanted to be heavily long equities but they wouldn’t even say that sentence 2 months prior. When the market normalises, it then starts to focus on real developments either through fiscal or monetary policy. Both are having MASSIVE shifts and will be the drivers through to the end of the year if/when this blows over.

We have Warsh taking charge of the Fed and Trump still yet to fully roll out things like tax cuts, and when the fiscal policy and plans really roll and transmit through the economy, I think FX is where the LEAST eyes are right now and where there will be the MOST sensitivity. That's where my concentration is shifting, building models to map out the implications of a change in both, but more so fiscal, because thats the underpriced driver in my view.

Here’s my visual view on how this plays out (1-2 months):

Both Capital Flows & Citrini have done an exceptional job of helping me understand the changes in AI and how to think about the shifts. Like any thesis I consider, I want to know what the path in the OPPOSITE direction looks like.

The AI doom-loop scenario has become the default mental model in macro circles. The argument logic is: AI displaces white-collar workers, workers spend less, companies invest more in AI to protect margins, AI displaces more workers. Rinse. Collapse.

I think this particular catastrophe is considerably less inevitable than the consensus believes.

This is going to be a piece arguing that transformative and catastrophically disruptive are not the same thing, and that the history of technology is far more littered with overhyped displacement predictions than actual displacement events.

1) The Capability-Deployment Gap Is Enormous & Structural

Every technology forecasting error of the last century shares a common structure: the gap between what a technology can do in a lab and what it actually does inside a real organisation is measured in decades.

Nuclear power was commercially viable in 1958. It still generates 19% of US electricity (less than it did in the 1990s). Autonomous vehicles were “five years away” in 2014. In 2026, they remain a novelty outside controlled corridors. The internet made physical retail “obsolete” in 1999. Physical retail still accounts for over 80% of consumer spending today.

AI is genuinely impressive. But deploying it inside the messy reality of a Fortune 500 with legacy IT infrastructure, compliance requirements, union contracts, regulatory obligations, and liability concerns, is a fundamentally different problem than running a demo. The enterprises that appear most exposed are precisely the ones with the most institutional friction slowing adoption.

The displacement scenario requires simultaneous deployment of AI across sectors with massively different regulatory environments (it’s not a one-size-fits-all), and organisational cultures. Enterprise tech spreads unevenly and with far more friction than the demos suggest.

2) AI Makes Labor More Productive

The assumption of the doom-loop is that AI substitutes for labor. The more probable outcome (and the one consistent with two centuries of technological history) is that AI complements labor, raising its productivity and its value.

The ATM was supposed to end bank tellers. Instead, ATMs reduced the cost of running a branch, which led banks to open more branches, which created more teller jobs. Word processing was supposed to eliminate secretarial work. It eliminated some rote tasks and expanded the universe of things a skilled administrative professional could do. Excel was supposed to end financial analysts. Instead, it made financial analysis so cheap to produce that demand for it exploded. You get the point…

In each case, the tech made individual workers more productive at their existing tasks and simultaneously created demand for entirely new tasks that only humans could fill.

The argument that “this time is different” because AI can learn new tasks is valid. But it also cuts the other way (a path I am mapping): an AI that makes every human worker three times as productive is not a labor replacement, it’s a labor multiplier that raises wages and living standards.

3) The “Last Mile” Problem Is Harder Than It Looks

AI performs impressively on the 80% of tasks that are well-defined, well-documented, and operate in structured environments. But it struggles badly on the 20% that aren’t, and in most professional contexts that final 20% is where most of the actual value resides. People will say that we’ll move to a 90/10 split, but it doesn’t kill the fact that there is a percentage outside of structured environments that AI isn’t fixing. Intuition and critical thinkers are needed.

A coding agent can generate functional software from a specification. It cannot navigate the internal politics of an organisation to understand what the specification should actually say. A legal AI can draft a contract. It cannot read the room in a negotiation, build the client relationship that made the negotiation possible, or exercise the judgment about when walking away is the right move. A financial AI can model a transaction. It cannot build the trust with a board of directors that gives a banker the mandate to advise on it. Once again, you get where I’m going with this.

This reflects something fundamental about the nature of organisational work: a large fraction of professional value creation is embedded in relationships, judgment (the biggest one), and context that doesn’t sit in any training set. The tasks most amenable to AI automation are, almost by definition, the lowest-value tasks in any professional’s portfolio.

What AI is most likely to do is compress the time professionals spend on low-value tasks, freeing them to do more of the high-value work that justifies their salaries. Will some jobs be lost? NO DOUBT. But to what extent is exactly what I’m arguing.

4) Demand for Expertise Expands When It Gets Cheaper to Access

One of the most consistent findings in economics is that when the price of a service falls, demand for it tends to rise, often dramatically. The displacement scenario treats the demand side as fixed. It almost certainly isn’t.

Today, only large corporations can afford sophisticated legal counsel, high-end financial advisory, or expert medical opinions. If AI makes legal and financial expertise an order of magnitude cheaper to access, the most likely outcome is that the market for their services expands dramatically to include the millions of businesses and individuals currently priced out.

Small businesses have historically operated without proper accounting, without legal review of contracts, without strategic financial planning, not because they don’t want these things but because the cost was prohibitive. A world where every SME has access to CFO-quality financial analysis is not a world with fewer financial analysts. It’s a world with more of them, serving a vastly larger market.

One thing that is key to mention is that AI is sector specific and will have different impacts at different stages in different parts of the economy.

This is the pattern with every technology that creates access to previously scarce expertise. The internet created more content, more journalists, and more niche publications than any previous era in history.

If 60% of today’s jobs didn’t exist before a period of time (1940-now) where MASSIVE evolution of tech happened, then I find it hard to believe that such an extreme in unemployment will happen in the development of AI.

5) Regulatory and Liability Constraints Will Slow Deployment in High-Stakes Sectors

The sectors most prominently featured in the displacement narrative (financial advice, legal work, healthcare, insurance) are also the most heavily regulated sectors in the economy which I touched on earlier. They are regulated precisely because the consequences of errors are severe, and because consumers cannot easily evaluate the quality of advice they receive.

Regulators do not move at the pace of demo videos. The FDA has spent five years developing frameworks for AI in medical devices and the SEC is still working through the implications of AI in financial advice, which tells us they could tighten regulations further.

This isn’t an argument that regulation will stop AI at all by the way. What I’m saying is that it will slow it dramatically in the highest-value professional service segments, while AI accelerates in less regulated domains. The result is a gradual, sector-by-sector restructuring (not simultaneously).

Add liability. When an AI-generated legal brief loses a case, who gets sued? When an AI financial model costs a pension fund billions, who bears the liability? When an AI diagnostic misses a cancer, who pays? Until these liability frameworks are resolved (and they won’t be resolved quickly), organisations face strong incentives to keep humans in every loop where the consequences of error are significant.

6) The Reliability Gap Between “Impressive Demo” and “Production System” Remains Wide

Current AI systems are genuinely impressive at generating plausible-looking outputs. They are considerably less impressive at reliably generating correct outputs in high-stakes, adversarial, or edge-case environments.

Hallucination rates in production AI systems remain significant. Models that perform well on benchmarks often degrade sharply on real-world tasks with distribution shifts from their training data. Agentic systems that work reliably in demos frequently fail in unpredictable ways when deployed at scale. These aren’t corner-case concerns they’re the primary reason enterprise AI adoption continues to lag consumer AI adoption by years.

Organisations with significant reputational capital at stake (banks, law firms, hospitals, consulting firms) have low tolerance for failure modes they can’t predict or explain. The more consequential the decision, the higher the bar for reliability. Current AI systems do not clear that bar in most high-stakes professional contexts, and the path to clearing it is not obvious.

Key Constraint

The economic value of professional work is disproportionately concentrated in decisions where errors are catastrophic (M&A transactions, medical diagnoses, legal strategy, credit underwriting). These are precisely the decisions where AI’s unreliability is most costly and most visible. The value-to-risk calculus strongly favors keeping humans responsible for these decisions, even as AI handles other tasks.

7) The Economy’s Response to Technological Abundance Has Historically Been Expansion, Not Collapse

The deepest flaw in the displacement spiral thesis is its treatment of aggregate demand as a fixed quantity being competed over. Economies don’t work that way. When technology makes things cheaper to produce, it creates purchasing power for new things that didn’t previously exist.

The industrial revolution actually CREATED consumer demand. Most of what we now consider necessities (indoor plumbing, refrigeration, automobiles, air travel) didn’t exist before industrialisation. The workforce also grew dramatically alongside an explosion in the range of goods and services people demanded.

If AI genuinely does raise productivity substantially, the most likely outcome is a rising standard of living, falling prices for AI-intensive services, and a reallocation of consumer spending toward new categories of goods and experiences that we can’t fully anticipate today. The history of technology is a history of this reallocation happening continuously, with net positive effects on employment and living standards.

The alternative (that humans will simply stop wanting things when tech makes existing things cheaper) has no historical precedent. Human desire for comfort, connection, status, experience, and novelty has proven remarkably expansive. The productivity gains from AI are more likely to create new categories of demand in my view.

What I’m Actually Watching For

None of this means the transition is costless or that policy responses are unnecessary. Technological transitions create real winners and losers, often with significant distributional consequences. There are workers in specific occupations who will need to retrain. There are regions economically dependent on industries facing disruption. These are legitimate policy concerns that deserve serious attention.

The question is whether these transitional costs cause a macroeconomic catastrophe or a manageable (if painful) restructuring. My base case is the latter.

The conditions that would push me toward the more catastrophic scenario are:

First, a step change in AI reliability that allows autonomous agents to make high-stakes decisions without human oversight across a wide range of domains simultaneously. We’re not there. The question is whether we get there faster than institutions can adapt.

Second, a regulatory environment that fails to impose meaningful liability frameworks for AI-assisted professional decisions, creating incentives for organisations to eliminate human oversight prematurely.

Third, an acceleration in AI capability that outpaces the demand expansion effect (most likely if any happen), such that the new jobs and industries created by AI genuinely cannot absorb the workers displaced. This would be historically unprecedented, but the pace of current capability improvement merits attention.

I’m watching all three. None have materialised yet. And until they do, the more probable outcome remains what it has always been when powerful new technologies arrive: disruption and restructuring (messy, uneven, and ultimately generative).

Firstly, see my report below for my thesis on the dollar, which I shared ideas for being short in both EURUSD & GBPUSD in the Substack chat:

1) As the market prices MORE cuts, ES is moving to the downside marginally. Just like I laid out in the dollar, there is LESS sensitivity to MORE cuts being priced. So unless an extreme is created in rate expectations (unlikely because the pricing for Z6 is fair), more front-end cut expectations will NOT drive equities, but a tightening of expectations could cause an outsized move DOWN.

2) Bonds are outpeforming equities on an intraday basis, equities are struggling and making weak legs higher, not with any real momentum vs bonds. Just look at everytime we come to this extreme in CS momentum.

3) On a Z score basis, VIX is trading above +1 (an extreme), all while energy, materials & staples drive equities (not what you want to see in a risk-on rotation). Value has also been the marginal driver in returns, once again not what you want to see if we’re setting up for a leg higher.

4) Equities have pretty much done NOTHING for the last 20 trading days, we’ve had the curve continuing to steepen, more cuts priced and BETTER growth data yet equities are NOT rallying, meaning there needs to be an extreme in data or pricing to drive equities from here in my view (which again, is unlikely).

5) Bonds have outperformed equities (not even on a voil-adjusted basis which is saying something). Yes, bonds can rally with equities but you want to see equities OUTPERFORM bonds.

6. FX CS momentum is beginning to trade in NEGATIVE territory, just like we did at the beginning of April. I DO NOT think we will see a leg lower asd we did back then, but I DO think this will cause downside pressures in equities.

Even as the short end bids higher and yields roll lower, the dollar is struggling to move with any like-for-like momentum. Yes, there is times that there’s disclocation between the front-end and the dollar. But when it trades with lower corrlation for a prolonged period of time, the move that can bring them back together can be sharp.

Last week convicned me that we could see the dollar trade higher as equities trade lower, but of course the key is the drivers. I wont repeat everything I laid out in the previous report but there’s some key things that are showing how much the dollar is struggling to move lower.

1) The dollars main driver, front-end rate expectations.

The terminal rate has been repriced marginally lower (about an extra 14bps), the rate now sits around 3% which is being solidified in the front-end. The issue is that this is causing NO marginal downward pressure on the dollar.

That’s evidence that markets believe US economic resilience remains superior even with rate cuts. If cuts are seen as extending the expansion while other economies face sharper slowdowns or recession, the dollar strengthens on relative growth optimism. The 2s20s is telling us that. For the last 2 months the curve has continued to be dominated by steepening, driven by higher growth expectations.

The danger here would be to keep being short USD because more cuts are being priced, as equity valuations remain strong and growth is priced in curves. That’s a danger because you’re assuming the path is linear, but rotation is causing upward pressure on the dollar in my view which directly causes LESS sensitiv ity in the dollar when the front-end prices in more cuts or the terminal prices lower.

An example is that in normal conditions, you’d expect movements in the front-end to cause a relatiively similar move in the dollar. But when we start having external pressures provide strength to the dollar, then there is much more movement in the front-end needed to cause any movement in the currency itself.

2) How bonds determine the extent of the move

The extent of the upward pressure in the USD and period of time is going to be driven by how the dollar moves relative to the front-end as bonds make higher highs. If we break this range below in ZT and maintain ABOVE the range as the dollar fails to create a leg lower, I’d expect the dollar to actually make a leg much higher than I anticipate now. But if we begin trading in a range in bonds from here, I’d expect the dollar to still trade towards 99.

I see the relationship as this: any movements in front-end yields LOWER will cause unnoticeable movement in the dollar, but re-pricing of the terminal rate HIGHER or front-end yields moving HIGHER will cause more of an outsized move in the dollar, HIGHER.

The implications of this doesn’t mean that equities can’t trade higher, in fact they COULD trade higher, but not with any momentum in my view. I laid out why the regime is still faovuring being long equities BUT the timing and price of positioning is important. We could also see a scenario where the dollar trades in negtaive correlation to equites as equities begin getting dragged further by rotation (likely in my view), just look at how defensive positioning has shifted in the sectors:

Equity vol is also causing marginal bidding in the dollar since the beginning of Feb. Equities have barely moved, we’ve been stuck in a range as implied vol rises from a combination of geopolitcal issues, rotation & even a shift in the Fed chair final outcome. Danger zone is here when VIX is trading above 1 on a z score basis, which it is.

Over the last month we’ve even seen bonds rally while causing marginal downward pressure on equities, as even equities are becoming LESS sensitive to changes in the front-end. When bonds rallying, you want to see equities outperform them with momentum as MORE cuts causes outsized upward pressure particularly in tech, but we haven’t seen that.

Skew is also posiitoned to see further upside in bonds. If we go off of the relationship we’ve seen as of recent, this means LESS upside in equities and MORE upside in the dollar.

Implied vol on the front end looks to have created a floor and is trading HIGHER

There’s also one key dynamic to point out. Even if tensions DON’T escalate with Iran and the U.S., oil trading at these higher levels price levels, implied vol and skew) causes upwards pressure on the dollar both directly and indirectly. Even if we created a top in skew & implied vol in oil, the levels at which we trade at through the next week matter A LOT. Basically, if we hold these levels and trade in these ranges as oil creates a higher high, then there is upward pressure on the dollar.

My view is that the dollar will begin to trade higher, towards the 99 level as bonds range and equities see marginal downward pressure.

Current trade tracker:

Firstly, notice how there is a divergence between inflation figures on a 3m/3m basis and breakevens. The market is clearly seeing higher inflationary pressures and views the rotation setup as temporary, adding more stickiness in the near future. This is definitely not a cause for concern yet in equities, as growth is still outperforming inflation. Credit risk is lower than duration risk in the system, which we have seen evidently in how bonds have traded recently.

Across the last 10 days, equity rotation has shifted and we’re seeing risk move toward safety: ES > NQ > RTY. Once again, this shift isn’t a direct signal that we’re topping out, as this setup happens many times while we are still rallying. However, NQ and RTY are negative as ES barely holds positive in a messy range, with further factors building to the downside.

Notice from a cross-asset performance stance that we’re seeing the highest-risk equity indices trade at the bottom of the table. With the Yen, bonds, and ES making their way into the top half, it is clearly a small rotation, but pressures are building, especially after the VIX blew out a little last week.

Now VIX is trading positive on a Z-score basis as equity Z-scores rotate to the downside. Clearly, there are more tensions in volatility as equity positioning shifts, causing a negative Z-score for equities. That is not something you want to see when positioning to the upside.

Credit has also flipped and is beginning to outperform equities on a Z-score basis as equities flip negative; this is a clear sign. I do not think there is a credit issue (no way, not yet) but what it shows is that higher volatility leads to higher-yield credit spreads, which is causing credit to be more volatile. The chart below is a very clear indicator of small equity drawdowns when credit Z-scores are positive and equity Z-scores are negative, showing a shift in positioning and risk appetite.

Probably the most telling factor is that sector performance and factor exposure across the last 10 trading days have shown that investors aren't carrying risk in higher risk-on sectors or factors. Value and growth are preferred as consumer discretionary leads alongside energy. While energy has been driven by the blowout in oil, I wouldn't disregard it just because it’s oil-related; in fact, that builds the case further because it shows just how volatile the last two trading weeks have been.

Now look at how the skew for USD FX pairs has shifted to the downside, yet positioning hasn’t followed much. Even when we saw this massive blowout in skew to the upside, we didn’t see equal pressure to the upside in equity indices. There is definitely some fatigue, but what could happen is that equities become more sensitive to downside skews, which will be telling as it looks like we’ve created a top in skew here. Implied volatility across these FX pairs is also starting to drop.

A shift in positioning (finally) for metals is also underway. Implied volatility is still high but slowing, while skew looks like it could shift. This will lead to big changes and rotations in portfolios (if the sell-off in metals hasn’t already) as managers rebalance their exposure.

Skew for 2Y, 5Y, and 10Y bonds is also rallying with some pace from lows. Some might say this is directly connected to the newly nominated Warsh (I don’t have an opinion on whether it is, but if I had to, I’d likely say it isn’t); regardless, positioning is still skewing to the upside in bonds. While equities can trade higher alongside bonds, when bond skew is blowing out to the upside, it’s not always pretty for equities.

Look at the forward curve below. We actually began pricing in more cuts (marginally, yes, but besides the point, still more cuts) and ES has had no reaction to the upside. I did actually mention in my previous report how the forward curve is causing less upside in equities; likewise, I don't think a hawkish shift would cause major downside because I think we are at an extreme in the forward curve which can’t really get much more hawkish (well, it can, but it wouldn’t make sense).

So here’s how I see things: we are structurally supportive of the upside in equities, but positioning does not favor me being long here. Much has shifted since Friday, and I think a small top-to-bottom drawdown of 3-5% makes total sense. I’m targeting the low side (-3%), but it will be key to watch the 2s10s and 10s30s to see how they react across the next trading week.

2s10s and 2s30s yield curve is bear steepening on a 60d lookback as we begin to price this reflationary regime. Bear steepenings (bonds selling off and long end rates rising faster than short end rates) had also been driven by the front end, controlled by policy of course. Now growth & inflation aren’t going to be immediate movers (e.g. if we see disinflationary pressures, it’ll show up in inflation swaps before 3m and 6m basis speed & z-score begin to signal we’re hitting a regime), so I like to watch the curve as a leading indicator to how the market is pricing the risks in the system.

You can see as we headed through the tariff saga in April, the curve actually began to bull steepen as the market priced higher growth in the long end, and rate cut expectations hit a peak (around 6 cuts at one point).

The tail-risk I see in mind for equities to continue making legs higher is if the curve flips back to a bear steepening regime because eventually, higher inflation prices will cause a larger drag on equities as growth exceptionalism slows. But we're not there yet, this is simply a tail risk to the idea. As of recent days we're moving into a steepener twist regime which is coherent to a regime where credit risk is low, and outpacing the safety of duration risk. One scenario that is feasible to keep equities pushing higher when we move out of a steepener twist regime is if we have a prolonged period of bull steepening (this is likely based on the front end).

STIRs are at an extreme, and policy pricing is stuck just below 2 cuts. I don’t think we’ll get less than 2 cuts for 2 specific reasons. Headline inflation could lead other inflationary metrics and we could see disinflationary pressure as inflation swaps tick down (less pressure on the Fed). 2) Growth is exceptionally strong but not strong enough to cause MAJOR reflationary pressures. Now that could change but based on what data we have, this is valid. Even if we deliver 50bp (not far off of STIR pricing), there would still be marginal upside pressure in bonds which would cause bull steepening, supportive of upside in equities.

One thing I noted in the substack chat was that we have seen lower reflexivity in equities and the STIR as the forward curve becomes more hawkish. Everyone loves to follow the Fed and say that when the forward curve reprices, it causes marginal downside pressure to equities but on an attribution basis this has not been the case. As rate cuts have been priced out, equities have remained strong, creating new ATHs clearly driven by growth in earnings regardless of a few labor market prints (that do not determine the whole regime itself).

There is also a case for a sharp repricing of STIR (I don’t think is likely), if the labour market has a shock in the coming months. The Fed are becoming more politically involved (especially Powell releasing a video on the topic of Trump) as fiscal policy attempts to pressure lower rates. I’ve said it 100 times, but as Trump builds out his Fed team, this will cause upside pressure in STIR only if disinflationary pressures persist and duration risk declines.

Real rates have ranged and pushed marginally down; I don't think they’re a cause for concern at these levels BUT if that shifts, I'd expect rotation out of the Russell into ES and down the curve. We’d probably begin to see marginal downside in bonds but ultimately not enough for me to get short because I think STIR pricing will drive them higher from these levels.

So in the coming weeks, I expect the 2s10s to continue a steepener twist with periods of bull steepening; I don't think we’ll enter back into a period of bear steepening. I think this is going to cause upside in equities. The Russell has outperformed NQ and ES across the last 20 trading days, yet has lagged on a cross-sectional momentum basis as of recent. I'm playing a catch-up in that; I'd rather be long the Russell than ES or NQ right now. I sent all my ideas in the Substack in real time and this is exactly how the trade tracker is looking:

That’s my current thoughts. Simple and to the point.

Have a good one!

Trade updates below. Open positions are now floating well over +2.5%. I was a bit early on the RTY breakeven, tagged it almost to the tick, and then it went on to rally more than 3%.

This is how the trade sheet is shaping up:

Macro setup

Stepping back, the current regime still makes sense for equities to grind higher, even if the pace is no longer explosive. Growth is holding up on a 3 and 6 month basis even with some softening in the very short-term labour data. Inflation pressures are present, policy expectations are fairly well anchored, and risk conditions are not flashing stress. The result is a market that can still move higher without needing a big repricing lower in rates or a weaker dollar to do the work. But ultimately, tail-risks here are building and have any marginal movements in them will cause outsized reactions in markets.

Yield curves are steepening through bear steepening, with both the 2s10s and 10s30s pushing higher. The combination of those two curves steepening usually reflects an economy that is still expanding. Real rates have been moving higher too (causing marginal pressure to equities), but not enough to say that we’re heading into a drawdown driven by restrictive rates.

Equity leadership reinforces that positioning is shifting. Energy, materials, staples, and industrials are leading, and factor performance is tilted toward size and value. That kind of rotation tends to show a market that is pricing ongoing nominal activity. Labour market tail risks also look contained. While hiring momentum has slowed a bit, there is no clear signal of a sharp deterioration that would force a sudden repricing of growth expectations. If we start to see industrials and tech move up this ladder on a 3 month lookback, with the curves still steepening then there is less pressure on equities from rotation.

Inflation is the more complicated part of the picture and is pushing us into a reflationary regime (for now). Inflation swaps have been rallying since early January, and most inflation metrics are positive on 3 and 6 month bases. Breakevens and nominal rates have both been moving higher on a Z score basis, which tells you inflation expectations are being repriced up and adding pressure to nominals. At the same time, core and headline CPI are slowing on a 3 month basis but I’m yet to call take this as disinflaitonary pressures. I’m watching the 6m speeds closely as we move into February. If we see 6m metrics shift, I think we could be heading into a goldilocksregime will will create at least another leg higher for equities.

This inflation picture matters for equities because the pressure channel right now is valuations. As long as growth keeps pace with inflation on a medium-term basis, higher inflation expectations do not automatically translate into downside for stocks. The real risk would be inflation accelerating faster than growth, which would compress multiples. That is not what the data is showing yet. Growth has outperformed inflation for over a year and for as long as this setup persists then equities likely wont be dragged by higher inflation. But like anything, things can shift fast.

Policy expectations help anchor this regime. The market is pricing just under 50bp of cuts by year-end, split between mid-year and later in the year (June & Oct). The terminal rate is sitting around 3.25%. Importantly, cuts have actually been priced out over the past month rather than aggressively added back in which is why the USD had marginal upside pressure as STIR repriced.

This also tells you markets are not leaning on policy easing to justify equity upside. The thing you want to do most often is run attribution analysis because at different times, different things drive the market. For example, you want to know how reactive equities are to STIR, growth, inflation etc at any given time.

This is also why downside in STIR looks limited coming into the next couple of months. If growth and inflation both continue on their current path, the front end may start leaning toward a 35bp outcome rather than 50. At that point, most of the downside in STIR is already behind us and the path of least resistance becomes delivering at least what is already priced. A scenario where disinflation resumes while growth holds would be outright supportive for both bonds and equities but would still likely only see 50bp priced. A scenario where the terminal rate is repriced much lower would likely only happen if growth weakens meaningfully, which would be a different regime altogether. There is a scenario where we could reach 75bp, but ultimately that’d be growth driven rather than any disinflatuion pressures in my view.

Positioning confirm the relatively easy backdrop. Put skew is moving lower (although we did see it blow out temporarily on Tuesday), implied vol is falling, credit spreads remain tight, and VIX is sitting near neutral levels. Equities are also outperforming credit on a Z score basis (I gave this indicator in the Substack chat), which tells you stress is not building beneath the surface... yet.

Breadth is another key support. Roughly 70% of S&P 500 stocks are above their 50d MAs, and equal weight continues to outperform. Momentum is rotating away from narrow growth leadership and toward the broader market. That is typically associated with slower but more durable equity upside (which is why I flagged that tail-risks hold more weight to equity downside than positioning). Small caps are lagging on a momentum basis and decoupling on correlation, which fits with a market that is cautious rather than euphoric.

For bonds, this setup argues for limited downside as I broke down above. With STIR expectations close to an inflection point and growth not collapsing, the asymmetry improves. You do not need a big rally in the front end for bonds to perform reasonably well, especially if inflation continues to slow on a medium-term basis.

FX ties the whole picture together. Despite tighter STIR pricing and higher real rates, the dollar has not responded meaningfully. Cross-sectional momentum in USD is negative versus equities, while correlation has risen. That tells you rates and fiscal dynamics are pressuring currencies without creating upside for the dollar. In other words, tighter policy expectations are not translating into a stronger USD, which removes a major headwind for global risk assets.

Putting it all together, this is a regime that still supports equity upside BUT at a slower pace. Growth is positive, inflation is firm, policy is tilting more restrictive than recent months, risk conditions are calm, and the dollar is not tightening financial conditions further. This is a setup to cap downside in rates, collapse the dollar, limit downside in equities, and keep the path of least resistance modestly higher rather.

Have a good one!

The BoE’s messaging still leans heavily on residual inflation risk and the need for patience, but OBR forecasts tell a different story. Inflation is projected to sit around 3% in early 2026, ease towards roughly 2.5% by year end, and fall below target sometime in 2027. That path does not justify policy remaining meaningfully restrictive (as it is), especially in an economy with weak trend growth and deteriorating labour-market conditions. Historically, when central-bank forecasts begin to sketch a clear disinflationary trajectory, the policy stance tends to follow with a lag. The UK looks increasingly close to that inflection point.

More important than the level of inflation is its momentum, and here the picture has improved materially. Inflation is smoothing out rather than re-accelerating. Services inflation is losing steam, goods inflation is no longer generating upside surprises, and there is no sign of a renewed inflation impulse of the type that previously forced the BoE to stay hawkish. This mirrors the recent US experience, where inflation rotated from a “sticky” narrative to a more controlled deceleration. In the UK’s case, that shift removes one of the last credible arguments for maintaining a highly restrictive stance. Both core and headline CPI have negative 3 and 7 month speed, with recent prints below both the 3 and 7 month averages, as inflation continues to become less of an issue... but by no means am I saying they have victory over inflation.

(Top = Headline CPI. Bottom = Core CPI)

Wage dynamics reinforce this point. Wage growth is easing from elevated levels and, crucially, is no longer accelerating in a way that threatens to re-ignite inflation. The feared wage price spiral has not materialised. Instead, wage growth appears to be responding to softer labour demand, rising slack, and weaker hiring intentions. As with inflation, the direction of travel matters more than the absolute level, and on that front the signal is clearly turning more benign.

The labour market itself is now the most important macro signal for the MPC. Unemployment has drifted above 5%, vacancies continue to fall, and hiring momentum is slowing across much of the private sector. These are not noisy indicators. Historically, once unemployment begins to rise in a sustained way, central banks shift their focus away from fine-tuning inflation outcomes and towards recession-risk management. The BoE is unlikely to be different. Faced with a weakening labour market, policymakers tend to prioritise cushioning the downturn rather than ensuring inflation is pinned perfectly at target.

(Top = Nominal GDP. Middle = Unemployment rate. Bottom = Job vacancies)

The decline in vacancies and hiring intentions suggests that labour demand is rolling over rather than merely cooling. This is the stage of the cycle where central banks often end up reacting more forcefully than markets expect, particularly if the deterioration continues over several months. Importantly, UK rates markets have not meaningfully repriced this risk yet. Only a limited number of cuts are priced, leaving significant asymmetry if labour data continues to weaken.

At the same time, higher rates, rising wage costs, and increased taxation are beginning to expose fragile corporate balance sheets. So-called zombie firms are starting to fail because financial conditions have remained tight for too long (although with fair reason). Taxes have played a major role here. Higher National Insurance, increases in the minimum wage, and broader tax pressures have all contributed to a quiet but powerful tightening of conditions for businesses. This form of tightening is particularly damaging because it is structural rather than cyclical.

Looking ahead, the near-term labour outlook is relatively straightforward. Job losses are likely to rise, unemployment should continue to drift higher, and inflation is set to tick lower. Yet markets are still pricing only a modest easing cycle of 2 cuts this year. That disconnect creates a clear vulnerability. If labour market weakness becomes more pronounced through the first half of the year, the repricing in rates is likely to be abrupt rather than gradual.

Growth provides little reason for optimism. UK trend growth appears capped around 1-1.2%, constrained by weak productivity, unfavourable demographics, and chronically low investment. More concerning is the composition of growth. Increasingly, whatever growth the UK does generate is driven by the public sector rather than private investment. That is not a sustainable engine of expansion and tends to coincide with lower productivity and weaker long-term potential.

Business investment remains well below pre-COVID levels and shows little sign of a durable recovery. Fiscal policy is not helping. If anything, it is acting as a drag. Rather than incentivising private investment, the current policy mix is weighing on corporate profitability and confidence. At some point, stimulus becomes unavoidable, and monetary policy is the most immediate lever available. Lower rates are not a panacea, but they are a necessary condition for stabilising investment and preventing a deeper slowdown.

Fiscal policy has turned from support into drag. Since Labour’s election win, the direction of travel has been clear: higher taxes, higher labour costs, and a tighter fiscal stance in growth terms. This represents a pro-cyclical tightening into an already weak economy. In such an environment, monetary policy is typically forced to do more of the heavy lifting. That argues for a faster and deeper easing cycle than markets currently expect.

Even after the initial cuts, policy is likely to remain restrictive in real terms, and has been for some time. With inflation easing along the Bank’s projected path, real rates would stay positive unless nominal rates are reduced more aggressively. This lowers the bar for additional cuts and increases the risk that the BoE ends up doing too little rather than too much if it moves cautiously.

All of this points toward a shift in the MPC’s priorities. As the cycle matures, the focus is likely to move decisively toward managing recession risk rather than guarding against residual inflation threats. Central banks rarely wait for full confirmation in labour data before acting, and the UK is now close to the point where pre-emptive easing becomes the rational choice.

Despite this, markets continue to underprice UK easing. Much of the global macro focus remains on the US, leaving the UK under-analysed and under-positioned. A base case of 75bp of cuts in 2026 looks reasonable in my take, with upside risk toward 100bp if unemployment continues to rise through the first half of the year (likely realised in market pricing by H2). The most powerful part of the repricing is likely to occur in the reassessment of the terminal rate, which remains too high given the UK’s structural growth constraints. The market is only pricing around 2 cuts this year with the terminal rate of 3.25% to be hit by year-end.

The divergence between the UK and the US reinforces this view. The UK faces weaker growth, poorer productivity, rising unemployment, and increasing fiscal drag. The US, by contrast, continues to benefit from stronger private investment, better productivity dynamics, and a more supportive fiscal backdrop. Even if both central banks ease, the UK is likely to underperform economically, and rates should reflect that divergence. This gap is driven by fundamentals, not by temporary policy differences.

In short, the UK easing story is a slow-burn macro mispricing. Inflation is easing, labour is weakening, growth is capped, and fiscal policy is restrictive. The BoE will respond in my view. Markets have not yet adjusted to that reality, and that gap is where the opportunity lies.

The cleanest way to express this view is via the UK front end, because that is where the repricing of both the number of cuts and the terminal rate should show up most directly. Conceptually, being long SONIA Dec-26 captures the point in the curve where growth fear can become most market-moving, especially if labour-market weakness continues to build into mid-year and the BoE starts to pivot more decisively. The appeal is that if the market moves from pricing a couple of cuts to a proper easing cycle, Dec-26 is a natural anchor point where those expectations concentrate. Timing-wise, the biggest convexity likely comes if there is a clearer catalyst around late spring into summer (May-June) or into the second half, when the accumulation of softer jobs data typically forces the market to stop hand-waving and start repricing.

I want to make it clear that I am unable to express the idea above due to asset limitations on my trading accounts. However, the trade below will be taken and added to the macro trade tracker.

A UK curve trade that matches this macro framing is a long UK 2s30s steepener. The logic is that the 2y is the cleanest instrument for repricing the depth and speed of cuts, and especially the shift in terminal expectations, while the 30y is less about near-term growth optimism and more exposed to term premium and fiscal credibility. In other words, even if the BoE cuts, the long end does not have to rally in the same way if investors demand extra compensation for fiscal drag, higher supply, and longer-run structural issues.

That is the key difference vs the US, where the long end can more easily reflect a higher growth, higher productivity narrative. In the UK, the long end is more likely to be anchored by supply and fiscal concerns rather than a bullish growth regime, which makes 2s30s a cleaner way to express front-end rallies on cuts while the long end stays relatively heavy. The trade in real terms is: buy 2Y Gilts and sell 30y Gilts. Profit as the yield spread widens (30Y yield rises relative to 2Y yield). For simplicity, I will be adding the trade as “UK 2s30s steepener” to the trade sheet.

This is how I view the setup for the UK 2s30s steepener, targeting 2% and invalidating at 1.3%:

So taken together, the trade framework is consistent: the front end is where the market is most wrong on the easing cycle, the UK vs US front-end spread is where the market is most wrong on the relative divergence, and 2s30s is where you express the view that cuts arrive without a great growth backdrop, leaving the long end more constrained by term premium and fiscal dynamics.

This is what the trade sheet looks like now:

Have a good one!

Now, I’m not going to bore you with real rates again, I’ll save that for another date. If you want a refresher on how real rate dynamics have directly driven equities, go back and look at the 2 reports I shared earlier. This one goes a bit more under the surface.

Sector leadership is critical to watch, but there isn’t just one correct mix that supports upside in equities. We’ve already seen that play out. From June to September, industrials, tech, and energy led. By year end, it was healthcare, tech, and industrials. Sector performance matters a lot, but you don’t want to fall into the trap of seeing healthcare leadership and immediately assuming the market is positioning defensively for an equity downturn. That mindset will make you miss setups and, worse, react for the wrong reason. Strong healthcare fundamentals don’t automatically equal defensive positioning.

This is the sector mix right now as ES has been pushing higher since late November.

If we exclude healthcare, since it’s only been a more recent contributor to this rally, I want to focus on industrials. This has been massively under discussed compared to tech, which floods my inbox daily. Industrials are quietly contributing marginal upside to broad equity indices, and they’re ultimately driven by regime dynamics. So the key question is, what do the fundamentals actually look like?

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Industrials

The XLI industrials ETF has been pushing higher with real momentum, up over 40% since the April lows. This has been driven by excess growth and inflation still in the system, all while SPX has been outperforming credit. Credit risk remains last on my list of worries for now.

Industrials are such a telling sector when it comes to recession risk. All year long people laid out endless recession scenarios, yet industrials kept making new highs and led all sectors. It’s always important to map out the risks in the economy and ask which one matters most. Duration, inflation, growth, or credit. Lay those out clearly and they’ll tell you a lot.

Industrials are influenced by multiple factors, but predominantly growth. And growth has arguably carried the lowest risk over the past 6 months, some would argue credit has. Inflation risk and duration risk, on the other hand, have posed far more downside threat to equities than growth. Simple as that.

When industrials are rallying, it’s a strong signal that recession risk is low. This sector sits on the front line of real economic activity. Orders, capex, transportation volumes, construction, manufacturing demand, all flow through here. Industrials usually weaken well before recessions, as companies pull back on spending. A sustained rally tells you the opposite. Firms are still investing, supply chains are active, and end demand hasn’t rolled over.

Historically, recessions don’t begin with industrials making higher highs. They begin when industrials underperform defensives and earnings expectations collapse. If capital goods, transports, and machinery are getting bid, the economy is expanding, simple.

The most important question is whether goods are actually moving. Looking at my purchasing managers basket model, it’s rallying aggressively alongside new highs in industrials. That is not a setup for an immediate downturn. Ultimately, growth in the system poses a low threat. If the doomers want to focus on something, it should be duration risk, which I’ll do a write up on soon.

So does the industrials sector have legs to go higher? Absolutely.

Beginning pretty zoomed out, a key macro question for 2026 is what happens to the FDI deals Trump negotiated. Bloomberg has tallied roughly 7TRN in commitments. Even if you spread that evenly, you’re talking about roughly 700BN of FDI next year. Even 250 to 300BN would be massively bullish for industrials.

Even a fraction of those commitments flowing through in 2026 would materially benefit industrials, infrastructure, and related sectors. Capital deployment at that scale drives revenue visibility and long term growth, which obviously creates a very constructive macro backdrop.

Another chart worth focusing on is the z score of expected new orders from regional Federal Reserve manufacturing surveys. In plain English, it shows directional intent inside the industrial economy, what manufacturers expect demand to look like going forward, not what it looked like last quarter. That distinction matters because equities trade expectations.

What jumps out immediately is the sharp rebound from deeply negative readings. Historically, when this series troughs at extreme negative z scores and then turns higher, it tends to mark inflection points in the industrial cycle, not peaks. This improvement is happening after a prolonged period of pessimism, inventory digestion, and cost pressure, exactly the conditions that usually precede stabilisation and re acceleration in orders.

This is occurring even though there’s widespread narratives around weak manufacturing, bankruptcies, and margin pressure. Industrial bankruptcies flush excess capacity, labour, and leverage out of the system. By the time expectations turn higher, much of the damage is already done and equity markets start looking through it.

From an equity perspective, expected new orders matter far more than current output. Industrials sit at the front of the earnings transmission chain. Rising order expectations feed directly into higher capacity utilisation, operating leverage on fixed costs, improving forward earnings revisions, and broader equity multiple support.

This also explains why industrials can rally even when backward looking data still looks ugly. Moving from very bad to less bad is often enough to drive meaningful price action in cyclical sectors.

Now let’s talk valuation. The free cash flow yield spread of solid waste companies versus the S&P 500 is extremely important. The sector is trading at its largest valuation discount to the index in more than a decade. Investors are being paid significantly more in free cash flow to own a core industrial services subsector than to own the market. That’s been very rare outside of major stress or mispricing regimes.

What makes this even more interesting is where we are in the cycle. Solid waste sits in the boring but essential corner of industrials. Volume linked, contract based, pricing power driven, and structurally tied to population growth, construction, and municipal spending. These are not businesses where earnings collapse without a deep recession. Yet the market has priced them as if structural demand is at risk, creating a valuation gap that looks disconnected from fundamentals.

Usually, when industrial sub sectors trade at material free cash flow discounts to the S&P 500, one of 2 things happens. Either the broader equity market de rates sharply, which usually requires a credit or labour shock, or capital rotates back into undervalued industrials as earnings prove resilient and cash generation remains intact.

So far, credit spreads are tight, labour is holding up, and capex linked demand is stabilising. That makes the second outcome far more likely. In that context, this valuation gap isn’t a warning, it’s fuel. It gives industrial equities room to outperform without needing heroic growth assumptions.

This also helps explain why industrials can lead even when sentiment is cautious. Attractive free cash flow yields invite buybacks, M&A, and private equity interest. That capital support matters, especially in a market increasingly focused on earnings quality rather than just top line growth.

Against an equal weighted S&P 500, the free cash flow premium in solid waste has compressed to its tightest level in more than 4 years. Against other industrials, the premium has eroded to the smallest level in over a decade once you exclude the pandemic distortion. In other words, the sector is no longer being paid a meaningful quality premium for stability. It’s being priced much closer to the average stock in the market and to its own peers.

That matters because solid waste is usually one of the last places where valuation premia disappear. When they do, it typically reflects crowded pessimism.. Cash generation hasn’t suddenly become cyclical. Contracts haven’t vanished. Pricing power hasn’t rolled over. Yet the valuation buffer that historically protected the sector has been stripped away.

Within a broader industrials led rally, this creates latent upside rather than confirming risk. Mean reversion here doesn’t require a booming growth rebound. It only requires earnings to stay boringly resilient, which is exactly what this part of the sector tends to deliver.

That valuation story becomes even more telling when you change the benchmark.

Now on bankruptcies. These charts look scary at first glance, but they are not a contradiction to industrial strength.

Industrials accounting for a large share of bankruptcies tells you where the tightening cycle hit first. Industrials are capital intensive, rate sensitive, and exposed early to inventory corrections, capex pauses, and refinancing stress. When financial conditions tighten, stress shows up here first, before it hits consumption, labour, or services. By the time bankruptcies are elevated, the damage is being absorbed.

More importantly, bankruptcies are micro failures rather than macro collapses. The companies filing are overwhelmingly smaller, over levered, poorly positioned operators. Not the balance sheet strong incumbents that dominate equity indices. Equity markets don’t price the survival of the weakest firms. When weaker players exit, capacity is rationalised, pricing pressure eases, and order flow concentrates among the strongest balance sheets. That is bullish for listed industrial equities even as headline failure counts rise.

Look at both 2024 and 2025 bankruptcies, all while industrials rallied… so don’t let doomers convince you that these factors mean industrials are cooked, because in EVERY sector you can find negatives (trust me). There’s also a timing mismatch that trips people up. Bankruptcy data is lagging. It reflects financing decisions made years ago under zero rate assumptions, not today’s marginal demand conditions. Equities discount forward earnings, forward orders, and forward margins.

That’s why you can see high bankruptcies alongside improving new order expectations, stabilising margins, and rising equity prices. One is backward looking stress resolution. The other is forward looking normalisation.

The sector breakdown reinforces this. Consumer discretionary, healthcare, and industrials dominate filings because these sectors carry operating leverage and debt structures that are most sensitive to rate shocks. As rates stabilise and financial conditions stop tightening, incremental stress slows and markets shift from fearing defaults to pricing survivorship and operating leverage.

From a broader equity perspective, elevated industrial bankruptcies do not signal systemic risk. Credit spreads remain contained, funding markets are functioning, and there’s no forced deleveraging across the corporate complex. Usually equities only struggle when bankruptcies spill into credit contagion and labour deterioration. That transmission literally isn’t happening.

What industrial equities are responding to now is cleaner balance sheets, improving forward demand expectations, and the asymmetric upside that emerges once excess leverage has been flushed out.

See you in the next one!

In my 2026 outlook, I mentioned upside risks to inflation driven by what I would describe as exceptional growth (exceptional relative to where policy rates have been held for an extended period). That said, forecasts themselves don’t mean much. I have views on what could happen over the next 1-3 months, but they remain merely ideas. I trade what the data is showing me now.

My view on equities trading higher from late-Jan is based primarily on curve steepening dynamics, strong growth on 3- and 6-month bases, and ongoing high-beta outperformance. However, it’s also important to recognise how unforgiving this environment has been. Since early November, directional positioning both long or short has been costly unless timing has been unusually precise. That alone argues for humility.

Breakevens

We have seen a meaningful shift lower in both 5y and 10y breakevens since mid-September following a sharp rally from April. Both are down roughly 30bp. This matters if the idea of inflation moving higher is going to remain viable. At the same time, breakevens are now closer to levels consistent with long run inflation targets, which complicates the upside inflation narrative.

Breakevens are also not a pure inflation signal. They embed real rate dynamics, liquidity conditions, and risk premia. Lower breakevens don’t necessarily imply that inflation risk has disappeared, only that the market is less willing to price protection against it at present. This distinction is important.

It is difficult to assess current equity reflexivity to inflation for two reasons. First, there has been limited inflation data over the past several weeks. Second, the holiday period typically dampens market sensitivity unless the data is extreme.

What remains reliable is the relationship between breakevens, real rates, equities, and bonds. Inflation swaps and breakevens remain the cleanest read on marginal inflation risk pricing, while real rates increasingly dictate equity duration sensitivity.

Directional drivers

Since the equity highs in late October, high yield and corporate credit spreads have remained relatively stable. This suggests credit is not actively forcing equity positioning in either direction. What has moved meaningfully is the relationship between real rates and breakevens.

Real rates have pushed higher while breakevens have compressed with speed. This combination is important. During the June to September equity rally, the persistent gap between low real rates and higher breakevens created a supportive environment for risk assets. Even when breakevens dipped, real rates were accommodative enough to sustain upside.

That buffer no longer exists. Marginal increases in real rates or further declines in breakevens now produce disproportionately larger equity reactions. However, recent real rate moves have not yet broken decisively higher. They remain sensitive to Fed expectations and incoming growth data, which keeps the regime unstable rather than clearly restrictive.

Inflation attribution

The primary driver of lower breakevens is composition. Disinflationary pressure is concentrated in goods and energy, while inflation persistence is increasingly isolated to slower moving service components.

Core goods are doing most of the disinflationary work. New vehicles, apparel, and medical commodities are flat to negative on a YoY basis, reinforcing the idea that supply side normalisation continues to feed through pricing. Used cars remain volatile, but the broader message across goods is clear. Pricing power has faded.

This disinflation is not uniform. Energy has recently shown YoY rebounds even as longer term pricing remains well below mid 2025 highs. Energy contributes asymmetrically to breakevens. Weakness pulls expectations lower quickly, while rebounds do not always reverse pricing with the same force.

Crude remains well below the highs seen during the Iran conflict in June. Policy pressure to keep energy prices low continues to cap upside, and looser discipline from OPEC has increased effective supply. Still, energy volatility remains a latent risk rather than a resolved factor.

Sticky inflation remains

Inflation pressures have not disappeared. Food away from home, shelter, transportation services, and medical services remain elevated relative to the broader basket. These categories are wage and rent driven and adjust slowly.

Markets increasingly treat this inflation as known, lagging, and unlikely to reaccelerate without a renewed growth impulse. As a result, it carries less weight in breakevens than faster moving components. That assumption may prove correct, but it also represents a vulnerability if wage growth or services inflation reaccelerates unexpectedly.

The net effect is divergence. Headline and market implied inflation expectations drift lower due to goods and energy, while underlying services inflation remains sticky but contained. Breakevens respond to marginal changes in inflation risk rather than the absolute level of prices, and that marginal signal currently points lower. This is not me discounting the significance of breakevens trading lower, but it’s just important to not take a bias in silo.

Market pricing

One divergence worth flagging is in metals. Silver has outperformed gold on a 20 day lookback even as gold continues to make new all time highs. This pattern usually aligns with improving growth, reflation, and risk on regimes.

At the same time, metals are not a clean inflation signal in isolation. Real rates (liquidity impulse), safe haven demand, and policy expectations also play a role. The signal is suggestive rather than confirmatory. It raises the possibility that inflationary pressure could still be building beneath the surface, but it does not yet force that conclusion.

Returns shading indicator above is from Capital Flows’ Substack.

What this means

We are no longer dealing with the level or speed of inflation pressure seen 3 months ago. That much is clear in the data. However, that does not mean upside inflation tail risks have disappeared.

Markets are currently pricing lower inflation swaps while asset performance still reflects an environment accustomed to higher inflation and strong nominal growth. That mismatch is the source of current uncertainty.

On a 3 month basis, most inflation components excluding core CPI are still showing neutral momentum. Because the lookback is short, January data will matter disproportionately. A shift there could materially alter the narrative.

What I am waiting for is alignment. Market pricing across breakevens, curves, real rates, and metals needs to confirm what headline inflation is showing on both 3 and 6 month horizons.

Bottom line

For now, conviction remains low in either a higher inflation or disinflationary regime. Growth still appears strong relative to expectations, but recent data suggests momentum is no longer accelerating uniformly. Inflation is the final variable needed before taking meaningful directional exposure in equities or bonds.

Until then, patience remains a position.

Have a great week.

The last couple of weeks have been pretty quiet. Some noise here and there, but nothing that actually moved markets. And when I say noise, I’m talking about things like the brief US bank failure “scare”, rumors flying around about a major bank going bust, which ultimately didn’t even move markets. I hate to break it to the doomers, but this just isn’t going to happen. Even that 12% probability floating around is way too high in my opinion.

Now, onto what actually will move markets.

Next up on the agenda is the Fed meeting on January 28th. I might sound like a hypocrite here because I tweeted the other day saying “don’t be that guy on Fed watch.” What I meant by that is the people who rely on a cartoonishly simple framework where Fed cut equals buy equities, Fed hold or hike equals sell. If only markets were that simple… yes, I do wish they were.

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What actually matters is how many times the Fed cuts over a given period, how aggressive that policy path is, where the terminal rate sits, and just how committed they are to achieving the dual mandate (lack of discussion around this part as of recent). There is virtually nothing priced into the January meeting right now, with most expecting a hold, but there is absolutely a scenario where those odds change. The speed at which monetary policy transmits this year is way more important than the amount of cuts themsleves. Simply ask yourself: how many cuts until the terminal rate? how many meetings before then? That will literally tell you how aggressive the policy is.

I’ve explained in previous reports that even if we don’t fully reprice to outright price in a cut, any change in the Fed funds curve matters. It has a direct impact on markets because it pulls cuts from further out closer in time. That changes the speed and aggressiveness of cuts prior to terminal rate, in other words, the path.

Before I break down the one thing that could reprice the next Fed meeting, I want to be very clear about the distinction between what should happen and what will happen. One of the worst mistakes you can make in markets is assuming that your thought process, even if correct, is how the market will price it.

That one thing is NFP on Jan 9 and the knock on effect from it. Later in the report I’ll explain why growth is still strong, but it’s important to remember that the Fed has been on labor watch for a long time. I’ve broken this down multiple times. They are far more reactive to labor data than inflation data. Powell would much rather tolerate higher inflation and not throw the economy into a recession, even if recession risk is low, than bring inflation to 2% while breaking the labor market.

Because of that, another weaker jobs print would likely cause a repricing of the January meeting. That probably looks like 10 to 15 bps being priced for a cut, which effectively gives the market a 50/50 chance of a cut by the end of January. Even if it doesn’t happen on FOMC day, the repricing itself is what matters.

On NFP figures, zooming out a bit, headline numbers have been declining pretty heavily on a semi-annual basis.

On top of that, the Fed’s focus on the dual mandate would absolutely not be comfortable with unemployment heading where it’s projected to go. A Bloomberg model shows that after incorporating the September jobs report and other October data, there’s a 1 in 3 chance of unemployment moving above 4.7%. Powell will do anything to avoid that outcome (even if the chances of getting there are low, no risks will be taken… I assume).

None of this means “the economy is doomed.” I’ll be very clear on that.

If markets truly believed the economy was heading into a labor driven recession, bonds would be rallying and definitely wouldn’t be stuck in a mean reversion regime while equities outperform them. High beta sectors (particularly industrials) also wouldn’t have lead across the last quarter, but they did.

On top of that, the S&P 500 has been underperforming RTY on a 3 month lookback. The Russell has the highest sensitivity to growth, especially labor and rates. If labor were an issue big enough to cause a slowdown, Russell 2000 companies would be trading much lower than they are right now. We’d see something very much like 2022 when equities were selling off across the board, with the Russell leading the fall quite dramatically. But instead, we’ve seen the Russell predominantly lead the S&P 500 for 182 days even as equities have ranged.

Indicator above from Capital Flows.

Cracks in the labor market show up at the margin first, not in headline unemployment. That’s why I focus on where stress appears early. Job openings are a great example. They’re showing positive momentum on both a 7 and 3 month basis, with the latest reading above both the 7 and 3 month means.

In a slowing economy, we wouldn’t be adding jobs... it’s simple. My thought process is that growth is strong enough to avoid recession, strong enough to support upside in equities, but labor data in isolation is not strong enough for the Fed to confidently pause across consecutive meetings. That’s the thesis I’m working with.

I honestly think the Fed holds at the January meeting, which is what’s priced in. What matters more is the repricing in the curve, especially for the March (H6) contract. If the market prices a 50/50 chance of a cut in January and the Fed doesn’t cut, the March contract likely becomes a fully priced 25 bp cut, assuming Fed communication doesn’t aggressively push back.

Once a contract is fully priced, it takes less movement in the Fed funds curve for equities to react. But as I always say, “less” liquidity from cuts being priced out or “more” liquidity from more cuts being priced in does not equal automatic positioning unwind or positioning upside. There are tons of moving parts.

Just look at how the 2s10s curve is starting to lead the 10s30s. That tells me the market is reacting more to policy and near term growth, while inflation, duration, and term premium risks are taking a backseat in the long end. What’s clear in both curves is the significant and prolonged steepening through December, after bull flattening briefly dominated as equities unwound at the margin.

As long as curves look like this, and the 10s30s doesn’t meaningfully lead the 2s10s, growth is not being crushed. Labor data in isolation, however, is enough to cause repricing in the curve. So to be clear, I’m not saying growth is cooked. I’ve argued the opposite. My view on growth and how the Fed reacts to siloed data like labor are two very different things.

I think the Fed holds in January, rates then fully price a cut in March, and that’s fine. I don’t care too much about being exactly right on that call in the near term. What I care about is positioning.

As I explained in my 2026 outlook report, equities aren’t positioned strongly enough, for several reasons I laid out there, for me to justify being leveraged long right now. Yes, I see more upside potential than downside risk, but that alone isn’t a reason to take leverage.

That said, this setup could eventually force positioning to favor more equity longs. My models aren’t signaling major long exposure yet, but when call skew shifts and we see some rotation in leadership, I’ll be much more confident holding long ES exposure into late January.

There are still plenty of moving parts. Unless vol blows out, ES begins to outperform Russell, cross border flow risk stays contained, credit spreads remain near cycle lows, and momentum starts climbing the factor rankings, I’m comfortable saying that long ES exposure is a position that likely gets expressed in the coming weeks.

Have a good one!

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Before we get into the actual macro views, a bit of housekeeping. From this year onward I’ll be running an active macro trade tracker (it will be a spreadsheet in the reports), so you can follow longer-dated macro positions alongside the reports that explain why they exist. This should make it far easier to keep track of trades that live for months. What I won’t be doing is sharing tactical intraday or intraweek positioning. Partly because it’s impossible to distribute in real time without destroying the risk-reward, but more importantly because I don’t want this to turn into a noisy signals page. The focus remains the same: structural regimes, big macro forces, and trades that make sense across time.

Now, onto the actual reason you’re here. This report is less about trade ideas, but instead a focus more on where I think we are structurally heading into 2026. The real value is not in trade ideas but in understanding the structural forces that bleed into everything else… equities, gold, small caps, FX, credit. The three anchors I care most about going into 2026 are: the Fed funds curve, real rates, and yield curves. But don’t worry, I will touch on the S&P500 at the end!

Having strong structural confidence 12 months out is brutally hard. There are hundreds of possible data paths that could derail any thesis within a couple of months. You might believe real rates grind higher, until an energy shock hits and inflation explodes. You might believe inflation fades, until geopolitics reminds you it exists. That’s why this report isn’t just about where I think we’re going, but where these views break. A bias without falsifiers is just useless. What matters is how long a regime can last and what kills it.

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Real rates & the Fed funds curve

If 2025 had a single dominant macro driver, it was real rates. Almost every meaningful shift in liquidity flowed through them. When real rates pushed higher, ES struggled and even gold came under pressure. When real rates fell, liquidity spilled into equities, gold, tech, and anything with beta. That relationship has been strikingly consistent.

My base case for real rates in 2026 is a trend lower, driven by inflation that stays sticky (from exceptional growth) while the Fed remains unreactive to higher inflation (I’m basing this on how they reacted through 2025 when inflation swaps and inflation metrics ticked higher while more cuts were being priced). The market already looks close to peak accommodation, with roughly 3 cuts priced, and I see that as the upper bound for 2026. In reality, I expect closer to 2 to actually be delivered if the inflation tail-risks are realised. Easing momentum has been pulled into the first half of the year rather than the second. If cuts begin to move back out to further contracts (September or December), then liquidity can contract fast (if real rates are directly impacted) and this will be something key to watch.

The consumer should remain supported, though far from euphoric, largely because the labour market is unlikely to crack in a meaningful way while rates sit at levels that don’t crush demand. Consumer spending held up well even as rates moved higher, with liquidity mitigating the impact. That resilience gives me confidence that a material break in the labour market remains unlikely.

Policy transmission remains slow, and in my view the Fed has already moved quickly to protect employment. The result is a widening of the inflation tolerance band toward something closer to 2.5-3% (as I laid out in my recent report), whether or not that’s ever said out loud.

Recent report:

The challenge for markets in 2026 emerges if inflation tail risks resurface after cuts are already priced or delivered. At that point, the Fed’s job becomes much harder. And the list of tail risks is long. Geopolitics hasn’t faded away… June alone was a reminder, with Israel targeting Iran in a strike. One escalation is enough to keep energy prices higher for longer.

Here’s the non-consensus piece most people overlook. The standard narrative says lower real rates mean more liquidity and more risk-taking. That misses a key layer. Liquidity only matters if there’s confidence and a willingness to deploy it. In 2026, we could see easier financial conditions, higher reserves, and lower money velocity at the same time. That’s a regime where asset inflation is uneven. If liquidity isn’t backed by confidence in growth, then crypto underperforms, small caps lag and the broad index rally will slow. Liquidity can expand but if it’s defensive, it means nothing for upside in equities.

Another real tail risk to “liquidity = risk-on” is a world where real rates fall because inflation swaps drift higher while growth plateaus. In this scenario, duration would trade higher, liquidity of course rises, yet equity multiples fail to expand cleanly… this is why liquidity doesn’t always equal risk-on. The early warning signs would be evident: inflation swaps drifting higher without excess growth expansion, tha't’s when you’d see gold and defensives outperforming ES, financial conditions would easing while earnings revisions stop improving… global macro doesn’t have equations where X always equals Y.

My rough framework puts a ceiling around 1.7% for the 5-year real rate, and even that would likely be brief, with a more plausible year-end outcome closer to (or below) 1.1%. Real rates remain the core transmission mechanism for liquidity. If you’re not updating those models continuously, you’re asking for trouble.

The primary falsifier for my view that real rates trend lower is continued downside pressure in inflation expectations. Specifically, if 5y breakevens remain below 2.05% and 10y breakevens below 2.10%, without a meaningful easing or re-steepening in the rates curve, then the real rate outlook breaks down. In that scenario, falling nominal yields would be driven by weaker growth rather than inflation persistence, implying real rates remain elevated or begin to rise. I would expect real rates to turn into a drag on risk assets, and would likely revise my year-end ES outlook lower (more on this at the end of the report).

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Yield curves

The 2s10s has done remarkably little since the April tariff shock, but I like to focus on the path more than the destination. Structurally, a steeper curve still makes sense as growth and inflation are being realised in the long end while the Fed eases the front end. But 2026 isn’t a straight line.

My base case for 2026 remains a gradual steepening of the yield curve, driven by easing at the front end alongside realised growth and inflation in the long end. That said, the path will not be linear. There are two secondary flattening scenarios I am monitoring closely, both of which could occur temporarily within an otherwise steepening regime. Please focus on the key word so that my overall outlook isn’t misunderstood… temporarily!

The first is inflation-driven flattening. The December 2026 (Z6) contract currently prices roughly 3 cuts. If inflation stalls or re-accelerates modestly early in the year, the market is likely to push those cuts out into 2027. That repricing would pressure the front end and open a short-lived bear-flattening window, potentially lasting a month or two, as investors are forced to reassess Fed credibility, another risk that remains surprisingly under-discussed.

Importantly, not all steepening is equity-friendly either. Bear steepening driven by rising term premium, rather than genuine growth optimism, is where risk begins to build. In that environment, the long end sells off even as the front end eases, duration risk overtakes growth risk, and equities lose their ability to hedge rate moves effectively. This is the core lesson of 2022, though in 2026 it would likely play out in a more muted form. What my focus is on, is what’s driving steepning rather that the steeepning itself.

The early warning signals I will be focused on are: long-dated yields grinding higher while growth indicators begin to roll, at the same time that inflation swaps hold firm, and FX volatility moves higher. When those conditions align, equities typically respond with a lag (and not to the upside…).

The second flattening risk is a growth scare, which markets tend to react to more violently than inflation scares. A run of weak labour or consumption data could pressure the front end again, producing a brief bull-flattening episode. However, this is not my base case. Labour data in 2026 is likely to become increasingly lagging and noisy, payrolls may hold up even as hours worked stagnate and real wage growth compresses through inflation. Given the strength of the underlying growth metrics outlined below, I view a persistent bull-flattening regime as unlikely, though all relevant falsifiers must continue to be monitored.

Why the curve direction and path matters is straightforward. If you trade rates, curve steepeners give you a partial hedge against exposure elsewhere in the portfolio. They need to be used carefully though. You don’t want the portfolio becoming overly directional, especially if you’re already leveraged long equities off the same regime view.

More broadly, the yield curve is a direct reflection of the macro regime we’re in. Growth, inflation, policy, liquidity, and credit all get priced into yields. If bear flattening persists for more than a couple of months, it becomes a genuine tail risk for being long equities. That’s why tracking yield-curve regimes matters well beyond just 2s10s. You need to monitor the whole curve and model the potential paths, in the same way you would for real rates.

A sustained bear flattening, particularly one driven by inflation pressure and a repricing of the front end, can easily mark an equity top. 2022 is the reminder everyone forgets. But as I laid out above, I believe that any bear flattening would be temporary.

Yield curve indicator from Capital Flows in this report:

Capital Flows

From Prosperity to Panic: The Credit Cycle Every Nation Follows

From Prosperity to Panic: The Credit Cycle Every Nation Follows…

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9 months ago · 33 likes · 2 comments · Capital Flows

Overall, I expect bull steepening to dominate the year, with one or two brief flattening episodes driven by inflation or growth scares. Prolonged bear flattening would be a serious equity warning, and that’s why curve regime tracking matters so much.

ES (S&P 500)

At its core, the price of ES is just a byproduct of multiple structural forces moving together… growth, inflation, and policy. That’s why the most important thing for you to do this year is build models that accurately map inflation, growth, policy, credit, liquidity, and volatility. ES simply reflects how those pieces interact. Rather than flooding you with the 40+ charts I use to track the regime, let me focus on the current state of play and the key dynamics we’re seeing right now.

As laid out above, I expect the curve to steepen through the year, driven by stronger growth and higher inflation. Crucially, I think growth accelerates at a faster and more aggressive pace than inflation. In that environment, higher realised long-end yields create less drag on equities because growth is outperforming inflation. The risk only becomes important when inflation runs ahead of growth, pushing the long end higher for the wrong reasons and weighing on equities because growth can’t offset the tail risk.

Alongside that, I expect real rates to trend lower, supporting liquidity that will be transmitted into equities (although I know this isn’t a direct relationship). With that framework in mind, the focus now shifts to the key signals that are pointing to where ES is heading next.

The factor exposure basket isn’t telling me ES is about to rally 5% in January, and it isn’t calling the end of equities either. What it is showing, over the past 3 months, is a clear shift in appetite. Growth and momentum have been slipping down the rankings, while concentration and value have moved into the lead. That isn’t a high-risk-on setup. For me to have high conviction that equities push meaningfully higher from January, I’d need to see that factor leadership rotate again.

Another, smaller source of concern for ES positioning sits in the equity put/call skew. We saw several months of upside chasing in the skew as equities rallied, tensions eased, and liquidity searched for risk wherever it could find it. More recently, equities have moved into a range, with downside covering becoming more visible in the skew. This isn’t an environment where I’d want to be running leveraged long exposure. Similar to factor exposure, I’d want to see a shift in the skew here before I position.

Sector performance over the last 60 trading days has actually been much more supportive of risk-taking. Even with healthcare sitting 2nd, the overall mix is strong. Industrials are leading, with financials and tech close behind. Risk is still being recycled into equities. That said, we’re not seeing this show up in crypto, which clearly has issues of its own.

As long as sector leadership doesn’t shift in a meaningful way… for example, utilities starting to outperform tech, then this backdrop remains supportive for upside in ES.

The factors above matter more for near-term positioning than for the structural regime, which is really defined by the yield curve, credit, volatility and real rates. My base case is continued range-bound action at best through January, before the setup becomes more attractive for holding leveraged longs towards 7800 (year-end), especially with credit spreads still sitting near cycle lows.

The key point is this: even when you have a strong structural bias on the regime, you still need positioning to line up before the odds favour being leveraged long. One of my performance models that monitors the 10y, RTY, breakevens and credit spreads below is currently signalling a risk-off regime. We don’t rely on a single confirmation, but for positioning this matters. Just look at how well the model behaved as equities rallied through 2025.

Structural bias doesn’t mean immediate leverage. You wait for the odds.

The big picture for 2026

To simplify it all:

• Real rates drift materially lower, driven by sticky inflation and an accommodative Fed
• Liquidity rises but confidence doesn’t materalise higher, velocity stays low in higher risk assets
• Yield curves steepen over the year, with short flattening episodes on inflation tail risks
• ES grinds higher unevenly, with rotation and dispersion doing the heavy lifting

My rough end-game looks like this: ES around 7800 after some drawdowns driven by curve repricing, real rates below 1.1%, and a structurally steeper curve defining the regime (with a period of flattening on inflation risk).

This won’t be like previous years where liquidity impulses always directly resulted in equity rallies. It’s a year where understanding how liquidity moves matters more than how much exists, and where macro discipline beats blind beta.

Wishing you all the best in the new year!