by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! Equity futures are off to a strong start thanks to a modest inflation report. In sports news, the Los Angeles Lakers “shocked the world” by drafting NCAA standout and USC star shooting guard Bronny James in the second round. Today’s Comment begins with a discussion about the first presidential debate, rising Treasury illiquidity, and the ongoing dispute between China and the Philippines. As usual, our report concludes with a roundup of domestic and international news.

First Presidential Debate: Although there was a clear victor in the debate, both candidates offered valuable insights into their visions for the next four years.

• Last night, both President Biden and former President Donald Trump presented their views on the state of the nation. Trump described the country as being in crisis due to rising immigration, elevated inflation, and increasing trade issues with China. In contrast, President Biden offered a more optimistic perspective, highlighting stronger job growth, progress in alleviating price pressures, and recent improvements in reducing border crossings. These contrasting viewpoints underscore how the two candidates will campaign in the coming months, each seeking to compare their records as president.
• Even though the national debt has become a pressing issue, neither candidate managed to clearly address how they plan to tackle it. While both mentioned raising revenue through tax increases, neither proposed significant spending cuts. President Trump focused on increasing tariffs, which raises the price that consumers pay for imported goods. On the other hand, President Biden advocated for raising taxes on high-income earners. Social Security benefits were a topic of discussion, but neither candidate presented a concrete plan to address the program’s long-term solvency. According to the Social Security Administration, the program’s assets that are available to pay benefits have been declining, while program costs are projected to rise.

• While it’s possible that neither candidate has a concrete plan yet, it’s more likely they’re focusing on popular policies without fully addressing the associated costs. The expiration of the 2017 tax cuts is likely to reignite debate on deficit reduction. We can expect differing approaches from the candidates. Trump will likely prioritize tax cuts and reduce spending, potentially targeting areas like climate change and social programs. Meanwhile, President Biden might advocate for letting the tax cuts expire to fund climate change initiatives.

Government Bond Liquidity: While the financial system appears stable, there are signs of financial stress bubbling beneath the surface.

• The Treasury market is flashing warning signs. Indicators like JP Morgan’s Liquidity Stress Dashboard and Bloomberg’s US Government Securities Liquidity Index are signaling a drying up of liquidity, particularly for bonds maturing within six years. This comes despite a seemingly strong bond market, with yields on the 10-year Treasury dropping 30 basis points in the past month. However, the turbulence in the Treasury market underscores growing concerns that the economy may not be able to absorb the high level of future Treasury issuance. It also casts doubts on the Federal Reserve’s ability to smoothly continue reducing its bond holdings.
• The decline in bond liquidity coincides with a shift in US debt ownership. As the Federal Reserve raises interest rates, foreign buyers, who are typically less concerned with price fluctuations (price insensitive), are reducing their purchases. This creates a gap that’s being filled by domestic households, who are more sensitive to interest rates and bond prices. The lack of interest rate-insensitive buyers of US debt is important because it raises concerns about whether the government debt could be attractive at lower price yields, particularly as inflation remains elevated.

• Shifting demand for US government bonds could prompt the Fed to adjust its balance sheet normalization plans. In June, the Fed opted to slow the pace of quantitative tightening (QT), a move likely aimed at easing pressure on bond liquidity, while also allowing the Fed to continue with its drawdown. Fed officials aim to reduce bank reserves from “abundant” to a more “ample” level, though they acknowledge the exact sweet spot remains elusive. However, if these Treasury liquidity indicators are truly signaling limitations, the Fed could ultimately decide to end QT prematurely, which would likely boost bond prices.

China-Philippines: Tensions between China and the Philippines continue to escalate in a spat that may lead to US intervention.

• In response to a recent clash in the South China Sea between the Philippines and the Chinese Coast Guard, the US reaffirmed its commitment to Philippine security on Thursday. The clash, which involved the sinking of a Philippine vessel and the alleged theft of firearms, has been seen as a hostile act by China. Following the incident, the US and the Philippines are set to continue with their pre-planned joint maritime exercises in the disputed waters, and they may include other countries such as Japan and Australia.
• The tense situation between China and the Philippines in the South China Sea has unnerved neighboring countries. Vietnam, Malaysia, and Indonesia also have territorial disputes with China in the region, raising concerns of a wider conflict. Despite seeking a peaceful resolution, the Philippines plans to send another supply mission to the Sierra Madre as early as next week. While the Philippine government has insisted that it can assert its sovereignty over the contested seas without the help of a US escort, the White House is already discussing potential responses to further Chinese aggression.

(Source: Wikipedia)

• The China-Philippines conflict in the South China Sea carries the risk of escalating into a black swan event. An attack on Philippine vessels by China could trigger the US-Philippines Mutual Defense Treaty, potentially leading to a direct military confrontation between the world’s two largest economies. This event would likely lead to a dramatic shift away from risk assets as investors look for safety until the situation resolves. This should benefit risk-free assets such as US Treasurys but could also be a boon for gold.

Other News: European Commission President Ursula von der Leyen was nominated for a second term, indicating that centrists still have significant influence in the European Union. French elections are set to take place next week, with polls showing that Macron’s party is likely to suffer a heavy defeat. Argentina’s President Javier Milei achieved a major victory after Congress passed his pro-business reforms, enabling the country to meet its fiscal targets.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! Equity markets are off to a sluggish start as investors await Friday’s inflation data. In sports news, the Atlanta Hawks chose Zaccharie Risacher with the first overall pick in the NBA draft. Today’s Comment will delve into the impact that immigration may have on monetary policy, our thoughts on the latest Fed stress tests, and a summary of the attempted coup in Bolivia. As usual, our report includes a roundup of international and domestic data releases.

The Immigration Conundrum: Foreign workers have played a pivotal role in filling job vacancies and easing inflationary pressures; however, the broader public wants fewer of them.

• Switzerland is set to address immigration concerns through a constitutional amendment that would require government action if the number of permanent residents surpasses 9.5 million. It would also impose a cap of 10 million on the total number of permanent residents. This vote coincides with Switzerland’s negotiations for an updated agreement with the European Union, where disagreements over wages and immigration persist. Businesses, especially in hospitality, share these concerns, highlighting their reliance on foreign workers to fill vacancies. The sentiment reflects a broader trend of rising skepticism towards immigration in Western countries.
• The debate over immigration intensifies as central bankers grapple with the pandemic’s impact on labor markets and inflation. A recent report by French economist Olivier Blanchard and former Fed Chair Ben Bernanke warns that persistent wage pressures — a key driver of inflation — are making it difficult for central banks to achieve their goals. Immigration has offered some relief by easing labor shortages. However, policy changes could undermine this progress, potentially forcing central banks to take stronger measures like rate hikes. As Fed Governor Michelle Bowman noted, stricter immigration policies could put upward pressure on inflation.

• The recent rise in anti-immigration sentiment could eventually influence monetary policy discussions. While increased immigration has helped address labor shortages and ease wage pressures, its impact is not one directional. Despite Fed Governor Bowman’s acknowledgement that the influx of foreign workers has helped alleviate inflationary pressures, she also suggested that it may have also contributed to rising rents due to the group’s housing needs. This mixed effect means immigration may become a factor that central banks consider, but it is unlikely to be the sole driver of policy decisions.

Is This Time Different? Major US banks all passed the Fed’s annual stress test this year, but there are still concerns that a financial crisis could hurt the economy.

• The stress test results indicate that these firms can withstand a major loss during a recession and still maintain sufficient capital to meet their obligations. According to the report, the group of banks would incur approximately $685 billion in losses, lower than the previous year’s figure and still within the acceptable range established by recent stress tests. While the success of these firms, as a whole, allows for more generous payouts through dividends and stock buybacks, the results did vary by individual firm. In the first, quarter, banks repurchased $14 billion worth of shares.
• The health of the financial system has been a major concern for investors ever since the Federal Reserve began raising rates in 2022. This concern is heightened by the FDIC’s latest quarterly report, which estimates that banks are currently holding a staggering $525 billion of unrealized losses on their balance sheets — a figure about seven times higher than what was recorded during the financial crisis. While banks can avoid recognizing these losses as long as they maintain sufficient liquidity, a liquidity crunch similar to the one that forced Silicon Valley Bank’s collapse in 2023 could trigger a wave of bank losses.

• The Federal Reserve, keenly aware of the financial system’s vulnerabilities, has been implementing measures to mitigate crisis risks. These include requiring banks to hold more collateral and making the standing repo facility permanent in July 2021. However, unforeseen geopolitical or financial events could still trigger a crisis, forcing the Fed to take more drastic actions. While there are currently no signs of an imminent crisis, the risk remains elevated as long as the Fed maintains restrictive interest rates. That said, any signs of a pivot should benefit these firms, especially small to mid-sized banks.

Bolivia Unrest: One of the largest producers of lithium narrowly avoided a coup on Thursday, highlighting the political uncertainty in small resource-rich countries.

• Bolivia narrowly avoided a coup attempt on Wednesday. Soldiers led by dismissed army chief Juan José Zúñiga stormed the presidential palace in an attempt to remove socialist President Luis Arce. Luckily, Arce was able to rally public support and regain control later that day. The motive behind the uprising remains unclear, but it may be linked to Arce’s recent efforts to reconcile with his predecessor, Evo Morales, ahead of upcoming elections. Notably, Zúñiga had been fired earlier this week for expressing opposition to Morales’ return to office.
• The recent coup attempt in Bolivia throws a wrench into South America’s efforts for regional integration. Last year, Brazilian President Lula da Silva spearheaded efforts, alongside other leftist leaders, to reunite President Arce and his exiled predecessor, Evo Morales, in the run-up to elections. Bolivia’s economy has sputtered since Morales’ departure in 2019, but the discovery of vast lithium reserves in July 2023 has offered a glimmer of hope. Last year, the country narrowly avoided a financial crisis after draining its gold reserves to sustain spending.

• Bolivia has a long history of coups with 23 attempts since 1950, 12 of which failed. In fact, the previous coup took place only five years ago. Unfortunately, political instability has long plagued emerging markets, particularly those reliant on resource exports. This trend is likely to worsen in a deglobalizing world and will likely have an impact on global commodity prices. As a result, investors should expect energy prices to become volatile over the next few years as countries look to form into regional blocs. Additionally, this fragmentation could potentially lead to higher global inflation due to persistent supply disruptions.

In Other News: Bulgaria and Romania failed to meet the economic requirements needed to adopt the euro. Their failure is a reminder of the difficulty in joining the economic bloc, particularly for Ukraine. A census report has shown that Hispanics fueled the US population boom in 2023, signaling their growing political influence.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with the latest on the simmering China-Philippines tensions in the South China Sea. We next review several other international and US developments with the potential to affect the financial markets today, including a new down-leg in the value of the Japanese yen, a bad inflation report in Australia, and, on a more positive note, signs of continued strong demand for junk-rated debt in the US.

China-Philippines: In an interview with the Financial Times, the Philippine Ambassador to the US warned that the China-Philippines dispute over the South China Sea’s Second Thomas Shoal has now reached an incendiary phase in which it could suddenly expand into a major conflict, much as the assassination of Austrian Archduke Franz Ferdinand sparked World War I. However, according to Ambassador Jose Manuel Romualdez, this conflict would be more dangerous because it could draw in countries with nuclear weapons.

• As a reminder, our new Mid-Year Geopolitical Outlook identifies the China-Philippines territorial dispute in the South China Sea as the world’s most dangerous geopolitical risk in the second half of 2024.
• While Beijing has deployed its coast guard and marine militia to quarantine a Philippine military outpost on the Second Thomas Shoal, using aggressive tactics to thwart resupply missions, Manila has also used provocative tactics to fight back, including by cutting Chinese fishing nets in the area and secretly delivering construction materials to shore up the outpost.
• What isn’t clear is the extent to which Washington and Manila are coordinating. One concern we have is that Philippine President Ferdinand Marcos, Jr., may be trying to force the US into backing his country’s sovereignty claim more forcefully.
• Since the US and the Philippines have a mutual defense treaty, which the Biden administration has repeatedly pledged to honor, Marcos may be trying to goad China into a violent action that would force the US military to make a show of force in the area. Ambassador Romualdez’s interview may also be aimed at prompting the US into action. Of course, the risk is that bringing US and Chinese military forces into closer proximity in the area could push them into conflict, even if accidentally.
• With our extraordinary focus on geopolitical risks here at Confluence, we are actively considering how we can adjust our investment strategies to hedge against such risks or take advantage of any resulting opportunities.

China-United States: In a new sign that the US is military is preparing for a potential conflict with China, the Marine Corps earlier this month recertified the airstrip on the Western Pacific island of Peleliu. In a major battle during World War II, the US sent 50,000 Marines and Army soldiers to pry the island and its airstrip from 10,000 Japanese defenders, resulting in tens of thousands of casualties. As discussed in our new Mid-Year Geopolitical Outlook, the US is now strengthening its presence across the Indo-Pacific region in an attempt to deter further Chinese aggression.

Japan: The value of the yen (JPY) today fell to 160.36 per dollar ($0.0062), reaching its weakest level since 1986. The currency has now lost some 12.2% of its value so far this year, as investors continue to be disappointed by the Bank of Japan’s slow pace of interest-rate hikes while the Federal Reserve and other major central banks keep their rates high. The new yen weakness will likely raise expectations that the Japanese government will again intervene in the currency markets to slow the currency’s slide.

Australia: The May consumer price index was up 4.0% from the same month one year earlier, well above both the expected increase of 3.8% and the April rise of 3.6%. A measure of core inflation rose to 4.4%. Coming just one week before a cut in income taxes and government payments to individuals to help offset the rise in the cost of living, the data has boosted expectations that the Reserve Bank of Australia will be forced to hike interest rates again. In turn, that prospect is weighing heavily on Australian stock and bond prices so far today.

North Atlantic Treaty Organization: In other security news, NATO’s member states today officially approved outgoing Dutch Prime Minister Mark Rutte as the alliance’s next secretary general. Rutte is seen as a strong trans-Atlanticist who can manage NATO relations with both the US and Russia. However, he has been criticized for the Netherlands’ failure to reach the NATO target of spending at least 2% of gross domestic product on defense throughout his time as prime minister. Rutte will take over the leadership of NATO on October 1.

Eurozone: The European Commission and European Central Bank today jointly announced that Bulgaria and Romania have failed to meet the economic criteria to join the eurozone, as widely expected. The countries’ key shortcomings included excessively high consumer price inflation and concerns that their institutions were too saddled with corruption and money laundering. The decision means that the eurozone will continue to encompass 20 countries; the last of which to join was Croatia at the beginning of 2023.

Kenya: The mass protests against the government’s new tax hikes, which we described in yesterday’s Comment, have now turned deadly, as police opened fire yesterday on protestors who had broken into parliament. According to local rights groups and activists, at least five protesters and first responders were killed and scores were injured in the incident. The violence threatens both the political and economic stability of a major African country.

Canada: The Wall Street Journal today carries an interesting article on Canadian oil sand companies and their recent outperformance. After years in which the firms were held back by high costs and limited export-pipeline capacity, they have now largely completed their expensive facility build-outs and are discovering improved operating practices to cut production costs. The May 1 opening of a new export pipeline to Canada’s west coast has also removed export bottlenecks. The resulting higher profits have pushed the firms’ stock prices sharply upward.

US Financial Conditions: New research from Goldman Sachs shows firms with low credit ratings have repriced some $391 billion in leveraged loans into lower-interest debt so far this year, a new record for the period. According to Goldman, the benefit from the repricing has been equivalent to a 0.50% cut in the Federal Reserve’s benchmark fed funds rate.

• The ability of the firms to roll their debt over into lower-interest loans stems from high investor demand for investment products that package the loans into securities.
• As illustrated by the rollover activity, burgeoning private credit funds, and the current low spreads for junk bond funds, high investor demand for yield is probably one reason today’s high interest rates haven’t sparked a broad financial crisis or thrown the economy into recession.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with further details on how Canada is considering antidumping tariffs against Chinese electric vehicles, as we flagged in a short blurb late last week. We next review several other international and US developments with the potential to affect the financial markets today, including another EU antitrust complaint against a major US technology firm and a statement by a Federal Reserve governor saying she would be open to raising interest rates if consumer price inflation doesn’t keep falling.

Canada-China: Following up on an item we flagged without detail late last week, the Canadian government is seeking public opinion on whether to impose antidumping tariffs or other barriers against Chinese EVs. Starting July 2, citizens will have 30 days to register their opinion, after which the government can decide on what it believes will be the optimal path.

• To justify the action, Ottawa cited “unfair competition from China’s intentional, state-directed policy of overcapacity and lack of rigorous labor and environmental standards.”
• More interesting, Ottawa said its goal is not only “to protect Canada’s auto workers and its growing EV industry” but also to “prevent trade diversion resulting from recent action taken by Canadian trading partners.” In other words, it is worried that the new US and EU tariffs against Chinese EVs will divert them toward Canada, where they likely would be sold at fire-sale prices.

European Union-United States: One day after accusing US tech giant Apple of using its app store to snuff out online competition, the European Commission today accused Microsoft of uncompetitive practices for the way it bundles its Teams collaboration tool with its Office products. The move appears to be another use of the EU’s new Digital Markets Act, signaling it will be applied aggressively and could trip up other US tech firms. If found guilty under the DMA, a firm could face a fine of 10% to 20% of its global annual revenue.

European Union-Ukraine-Moldova: EU officials today will meet with Ukrainian and Moldovan officials in Luxembourg to begin talks on their accession to the bloc. At the meetings, the EU will outline the reforms and legislation each country needs to adopt before being deemed ready to join. However, both Ukraine and Moldova are likely to need several years to meet the EU’s standards, so joining is by no means imminent.

• In large part, the talks will be symbolic, since they are merely aimed at getting the ball rolling before Ukraine-skeptic Hungary takes over the six-month rotating presidency of the Council of the European Union on July 1.
• Our next Bi-Weekly Geopolitical Report, to be published on Monday, will provide a full explanation of what that Council is and how it fits into the EU’s decision making.

France: With polls showing the far-right National Rally could win the parliamentary elections starting on Sunday, leader Jordan Bardella yesterday held a press conference to unveil new details on the party’s economic, immigration, and foreign policies. To counter concerns that the party’s populist bent would lead to tax cuts and spending hikes, blowing out the French budget deficit, Bardella vowed that National Rally would actually bring the deficit back down to the European Union limit of 3.0% of gross domestic product by 2027, versus 5.5% of GDP last year.

• Besides vowing “reasonable” fiscal policies, Bardella also outlined an economic program that largely echoed President Macron’s mainstream goals of strengthening the French industrial base, boosting employment, and cutting regulation. The main difference was that Bardella said National Rally would reverse Macron’s pension reform, which raised the national retirement age from 62 to 64 years.
• Bardella’s economic proposals illustrate how many of Europe’s populist, far-right parties have moderated their policies once they attained power. One example of that has been Italian Prime Minister Giorgia Meloni and her Brothers of Italy party.
• If that turns out to be the case in France, the recent sell-off in French stocks and bonds could well be an attractive buying opportunity.

Israel: The Israeli Supreme Court today ruled that ultra-orthodox Jewish students cannot be legally exempted from military conscription. It also ruled that those students aren’t entitled to government funding if they don’t have a valid conscription exemption. While it remains unclear when the ruling will be implemented, it will eventually end a controversial practice that many Israelis see as unfairly benefiting ultra-conservative citizens. It could also weaken the cohesion of Prime Minister Netanyahu’s right-wing coalition government.

Kenya: Protestors have launched nationwide demonstrations against a new set of tax hikes the government hopes will raise some $2.1 billion and help cut the budget deficit from the current 5.7% of GDP to 3.3% of GDP next year. The tax hikes are required under Kenya’s most recent bailout deal with the International Monetary Fund. The protests have already turned violent, threatening political and economic instability in the country.

US Monetary Policy: In a speech today, Fed board member Michelle Bowman said she would be willing to raise the benchmark fed funds rate again if progress on lowering consumer price inflation stalls or reverses. According to Bowman, one key upside risk for inflation is the large federal budget deficit, which reflects factors such as weak tax revenue, higher interest costs, and increased outlays on Social Security, Medicare, and other programs. She also said high immigration could drive up the price of housing, even if it helps hold down wage rates.

US Manufacturing Sector: Danish pharmaceutical giant Novo-Nordisk yesterday said it will invest $4.1 billion to build a new factory in Raleigh, North Carolina and expand production of its blockbuster weight-loss drugs Wegovy and Ozempic. The move will likely put pressure on US drug giant Eli Lilly to expand output of its rival drugs Zepbound and Mounjaro. The investments would add to the current boom in US factory construction, which to date has been driven more by manufacturing facilities for electronic goods such as electric cars and semiconductors.

US Artificial Intelligence Industry: The Recording Industry Association of America has filed copyright infringement suits against two AI startups developing products that allow users to generate new music using text prompts. The suits, brought on behalf of major music companies, allege that the startups used copyrighted works scraped from the internet to train their models.

• The suits illustrate the legal challenges that have to be sorted out for the AI industry to continue growing.
• One likely result of such suits is that specialized data sets that are useful for training AI models will become increasingly valuable. Those data sets will be guarded furiously, potentially to the point where specialized, focused AI models will proliferate and become even more important to the economy than the general AI models getting so much attention today.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with a new antitrust suit by the European Union against US tech giant Apple. The suit suggests major US tech firms will be in the crosshairs of the EU’s new Digital Markets Act going forward. We next review several other international and US developments with the potential to affect the financial markets today, including new polling showing that the far right and far left are likely to dominate France’s parliamentary elections this Sunday and details on an ongoing cyberattack affecting US auto dealerships.

European Union-United States: The European Commission has accused US technology giant Apple of stifling competition on its App Store. The action marks the first major application of the EU’s Digital Markets Act, which went into effect in March and aims to keep big, powerful online platforms such as Apple’s from squashing competition from start-ups. If found guilty, Apple could face a fine of 10% to 20% of its global annual revenue, or tens of billions of dollars.

European Union-China: European and Chinese officials over the weekend confirmed that the EU and China have agreed to start talks over the growth of Chinese electric vehicles in the bloc, which EU officials fear will put legions of Europeans out of work. The talks aim to diffuse the EU’s planned antidumping tariffs against Chinese EVs, which are due to come into effect in July. At this point, however, we see no reason to think the talks could head off those tariffs.

France: Ahead of the snap parliamentary elections next Sunday, a new Financial Times poll shows 35.5% of voters intend to cast their ballot for the far-right populist National Rally, while 29.5% intend to vote for the new far-left alliance called New Popular Front. President Macron’s centrist Ensemble alliance, including his own Renaissance liberals, has the support of only 19.5%. As of right now, the figures suggest the runoff election on July 7 could pit the far right against the far left, guaranteeing a major change in France’s domestic policies.

Philippines-China: Satellite imagery shows the Philippine government has begun building an anti-ship missile base on the west coast of Luzon island, facing the South China Sea. The new base is aimed at deterring Chinese aggression against disputed islands and shoals in the area, including the Second Thomas Shoal, which we think is a particularly dangerous source of friction between China and the Philippines.

Russia-Germany: According to Western security officials, communication intercepts show that a fire last month at a Berlin factory owned by defense contractor Diehl was set by Russian saboteurs trying to disrupt shipments of critical arms and ammunition to Ukraine. Confirmation that the fire was an act of sabotage has prompted a call for similar incidents to be re-investigated for any link to Russia. Of course, such aggressive Russian attacks on NATO soil run the risk of worsening NATO-Russia tensions going forward.

Russia: Terrorists yesterday attacked a synagogue, two churches, and a police station in the restive North Caucasus republic of Dagestan, killing four civilians and 15 police officers. The attacks suggest Islamist militants could be taking advantage as the Kremlin shifts its attention and resources to the war in Ukraine and the fight to control political dissent.

US Cybersecurity: The cyberattack on auto dealership software provider CDK Global that started last week continued through the weekend, disrupting dealership business. Statements from CDK Global suggest the attack involved ransomware, in which the attackers shut down a system until a ransom is paid. The attack illustrates how specialized software for particular types of businesses have the potential to shut down large swaths of an industry.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! Equity futures are holding steady as investors wait for fresh economic data to guide their next move. On the sports front, Argentina emerged victorious against Canada with a 2-0 win, setting the stage for the Copa América. Today’s Comment dives into three key topics: the persistently low bond yields, the recent restrictions on Chinese electric vehicle imports, and the performance of banks. We’ll wrap up the report with a look ahead to today’s domestic and international data releases.

Bonds are Back: Bond investors continue to doubt whether the Fed will hold rates steady as the economy continues to show signs of slowing.

• The yield on the 10-year US Treasury note remains stubbornly low, closing below 4.3% for the tenth consecutive day on Thursday. This defies expectations given several headwinds: the Fed’s recent shift towards fewer rate cuts, stubbornly high inflation, and a ballooning Treasury supply. Investor demand for bonds seems fueled by a confluence of factors. One is the hope that inflation will continue to cool in the coming months. Additionally, economic uncertainty is driving a flight to safety, pushing investors towards the perceived security of Treasurys. Finally, a string of weak economic data has reinforced the cautious market sentiment.
• The Fed’s recent slowdown in quantitative tightening, from $60 billion to $25 billion a month, might also be contributing to the decline in bond yields. This shift in policy suggests a less aggressive approach to draining liquidity from the financial system, potentially making long-duration assets more attractive to investors. While the two-year quantitative tightening program nears its final phase, the Fed plans to use the reduced pace of balance sheet reduction to ensure a smooth transition from abundant liquidity to ample liquidity. Phasing out this program will likely ease pressure on bond yields and provide support for stocks.

• However, further declines in Treasury yields are unlikely in the short term without clear signs of inflation subsiding. The Fed’s May decision to accelerate balance sheet reduction reflects its confidence in remaining patient as inflation pressures ease. Notably, the core PCE price index, the Fed’s preferred inflation measure, has shown a slower pace of increase in the first four months of this year compared to 2022 and 2023. For sustained confidence in inflation’s retreat, the index should continue this trend and align with pre-pandemic levels over the next three months.

The West’s EV Problem: Tensions escalate in the West-China trade dispute as Canada joins the fray.

• Canada is considering raising tariffs on electric vehicles (EVs) imported from China. This move aligns with similar actions taken by its allies such as the United States and the European Union. The concern is that China’s rapid growth in EV production could harm domestic auto industries. Earlier in 2024, the US significantly increased tariffs on Chinese EVs to 102.5%, while the EU implemented tariffs as high as 38% on specific vehicles. Canada, with its current 6% tariff, is exploring raising it to match the approach of its partners. However, a final decision on Canadian tariffs remains pending.
• The proposed tariff increase on Chinese electric vehicles comes as the Western green industry faces challenges. Weak domestic demand is hindering growth, as evidenced by EV startup Fisker’s recent bankruptcy after halting production. At the same, Tesla’s stock price also reflects these difficulties, dropping nearly 27% this year following its announcement of a tough industry outlook. Europe shares these struggles, with a particularly sharp decline in Germany. Last month, EV sales in the Continent’s largest economy plunged by 30%, while the broader European market saw a 12.5% drop.

• The fight for leadership in green technology shows no signs of slowing down, even though Western nations face challenges in attracting consumers to some eco-friendly products. Affordability appears to be the biggest hurdle, with electric vehicles remaining out of reach for many households and governments becoming more selective when offering subsidies. Tariffs on Chinese EVs might not be the silver bullet. While they could limit Western sales, they might also boost demand in emerging markets. In the meantime, Western governments may need to acknowledge that consumers are not yet fully prepared to abandon their gas-powered vehicles.

Higher-for-Longer and Banks: Banks in the US and abroad are facing headwinds as they struggle to attract deposits and protect their balance sheets, but there are no signs of a crisis.

• Japan’s regional banks are facing increased scrutiny as interest rates rise. Moody’s rating agency warned last month that higher rates could lead to capital flight, potentially harming these banks. Similarly, S&P Global expressed concerns earlier this month that rising rates could pressure the capital ratios of regional banks, especially those with high buffers. This isn’t a solely Japanese issue. US banks are also under the microscope. Moody’s recently placed several American banks on watch for downgrades due to their exposure to the potentially risky commercial real estate market.
• The threat to bank profitability appears likely to persist as long as interest rates remain high. This current rate cycle has negatively impacted bank balance sheets, putting pressure on some major institutions. For example, Norinchukin Bank, a Japanese agricultural lender, announced it would unload $63 billion in low-yielding US and European government bonds. This move aims to stem losses following an unsuccessful gamble on falling interest rates. In contrast, US banks have been increasing their holdings of short-term, floating-rate collateralized mortgage obligations (CMO) backed by Ginnie Mae. This strategy aims to protect themselves from potential deposit flight if interest rates continue to rise, but exposes the banks if rates fall significantly as it could lead to a wave of refinancing.

• While rising interest rates pose challenges for the financial system, there aren’t immediate signs of a crisis. This can be maintained if central banks prioritize clear and open communication about their interest rate expectations. Additionally, banks must avoid excessive risk by not over-committing to specific forecasts on Federal Reserve decisions. The pandemic highlighted the dangers of banks relying too heavily on, or outright contradicting, Fed guidance. This approach may be viable in a stable environment, but it becomes riskier during periods of high inflation volatility and geopolitical uncertainty.

In Other News: Purchasing Managers Index (PMI) surveys suggest European economies are not as robust as previously thought. This could fuel expectations of further rate cuts from the ECB. US car companies face challenges from cyberattacks, highlighting the need for further investment in cybersecurity. The Philippines’ undisclosed reinforcement of a ship in the South China Sea could lead to heightened tensions with China.

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