Five-dimensional chess

In his latest weekly insight, Mark Dowding, BlueBay CIO, RBC BlueBay Asset Management. In this edition, looks at the outlook for the US, Europe, and Japan.

The Fed: This week’s CPI report was relatively benign at 2.8% on the core measure, although upside risk to prices, as a result of tariffs and supply chain disruptions, could see higher numbers in the months ahead. Anyway, it strikes us that the Fed can sit vindicated in its decision to stand pat on interest rates.

Yet, newsflow in the past week shows why the central bank can’t get pulled into a game of guessing where the economy may go (despite frustrations from President Trump and others on the Fed Chair’s reluctance to give away too many clues with respect to forthcoming rate cuts), based on survey indicators and the latest policy announcements, in an environment of such uncertainty.

Instead, they need to retain discipline with respect to analysing hard economic data and adjusting policy so as to minimise any overshoot on inflation or unemployment that would take them in a direction away from their desired objective. 

Treasuries: With yields moving up in the past week, futures markets now only discount two Fed cuts later this year, in line with the March dot plot. This is a material adjustment to the four rate cuts being priced as little as a couple of weeks ago. Meanwhile, 10-year yields at 4.5% also appear reasonable, though RBC BlueBay sees risks toward higher yields at the longer end of the curve; 30-year rates may breach 5%, partly as recession fears recede, but also, in part, as debt investors focus on the concerning state of the US Budget. 

Risk assets: Up until now, higher government bond yields do not seem to have dented enthusiasm for risk assets much. The past week has seen investors remove recession hedges and re-engage with risk assets, as fears in the near term have been pushed to the back burner. However, with markets having reversed most of their previous 2025 year-to-date losses, there is limited scope for further compression. On this basis, RBC BlueBay feels that it continues to make sense to pare risk into strength and await clearer opportunities ahead, as they present themselves. 

Bank of Japan: RBC BlueBay has been surprised that declining fears over the US economy have not raised expectations that this will enable the BoJ to continue to normalise monetary policy as we move through 2025, with wages and price inflation well ahead of the central bank’s 2% target. RBC BlueBay thinks that, with the yen having also reversed a chunk of its prior gains versus the dollar, there is a building case in favour of the BoJ hiking rates at its meeting in July. As RBC BlueBay believes that rates markets materially underprice BoJ rate hikes, the firm has added a short position in Japanese yen two-year swaps at a yield of 0.70%.  

Spending in Europe: There has been some renewed attention on French politics and the potential vulnerability of the Bayrou government. A near-term collapse and new elections seem unlikely at the moment. However, the need for France to deliver spending cuts to avert further growth in the fiscal deficit remains a fault line that can easily become exposed. With Germany loosening the fiscal reins and a push for greater EU defence spending, this highlights that much of the required spending may need to be done at a joint EU/ESM level, rather than putting pressure on national budgets.