Overview of Cross-Currents

Since the beginning of October (quarter-to-date), we have seen cross-cutting pressures result in both upswings and downswings across global bonds and equities. As the first table below illustrates, we saw both equities and bonds across the curve rally in October (with Japanese long duration bonds an exception). We’ve since seen that market action reverse in November, with a broad-based global equity correction and mixed market action in global yields (long duration yields notably rising around the world) – in other words, a modest tightening in financial conditions. The second chart below illustrates price action in U.S. equities over the quarter, emphasizing key dates and cross-cutting pressures: while the S&P 500 is basically flat over the period, there were significant downswings and reversals.

The most important drivers of price action in markets are listed below, each explored in greater detail.

1. Monetary policy remains accommodative, but U.S. policymakers are flying in the dark, as economic data is still scarce even though the U.S. government shutdown has ended, and are facing tough trade-offs. After the FOMC eased another 25bps at its October meeting, further accommodation is far from guaranteed in December, with fed funds futures pointing to about 45 percent odds of a 25-basis point cut. A more hawkish-than-anticipated Fed could add to pressures in credit markets, which are already showing signs of strain.
   
2. While the end of the U.S. government shutdown and associated disruptions may provide a sentiment boost in the short-term, it will take some time for investors to assess underlying trends in economic activity, adding to uncertainty to the economic outlook.
   
3. The China-U.S. trade truce reached at the end of October contributed to the increase in U.S. equity prices, but tensions remain and further escalation between the two economic superpowers remains a major tail risk for the global economy.
   
4. On the whole, U.S. Q3 earnings have so far come in slightly above consensus expectations, for both total market earnings and mega-cap tech earnings. However, stock prices of some Mega-cap tech companies have declined, as investors continue to assess the return-on-investment that will be required from ever-increasing AI-related capital expenditures. What seems to be clear from earnings season – the AI capex boom is accelerating. With more of the capital expenditures anticipated to be funded with debt going forward, the big question is whether there is an AI bubble in markets.

These forces may continue to be constructive for risk assets in the short-term. However, unless anticipated AI-related productivity gains materialize in the next few years, investors may face disappointment in the medium term, as market pricing does not appear to be reflecting many of the potential tail risks.

Zooming out to year-to-date, the rally in U.S. (and global equities) has been significant, with this year’s rally ranking in the 75^th percentile of equity price moves over the same period since 1980.

Market optimism (and low odds assigned to tail risks) is visible in investor sentiment, positioning, and elevated valuations. The correction in equities this month illustrates how given current pricing, sentiment, and positioning, it may not take much disappointment for markets to reprice.

Accommodative Monetary Policy Under Pressure

Monetary policy continues to be very accommodative. The FOMC lowered the target for the federal funds rate another 25bps at its October meeting and announced that balance sheet runoff is coming to an end beginning in December. The FOMC’s easing stance despite ongoing strength in the economy and upside risks to inflation has been a boost to the economy and to risk-asset markets.

With little economic data released during the government shutdown and limited additional data set to be released before the FOMC December meeting, policymakers are navigating in the dark. A continued deterioration in the quality of inflation data is also adding to the challenges.

Chairman Powell also made it very clear that further easing at the December meeting is far from a foregone conclusion. Markets are pricing in less than a 50 percent probability of a rate cut at the December meeting, and three to four cuts in total through the end of 2026, setting the stage for a possible disappointment should the FOMC turn out to be more hawkish than anticipated.

There is no risk-free path for policy as we navigate this tension between our employment and inflation goals… In the Committee’s discussions at this meeting, there were strongly differing views about how to proceed in December. – Chairman Powell, October 29^th

What do you do if — what do you do if you’re driving in the fog? You slow down. So that could or could not, I don’t know how that’s going to play into things. We may get — the data may come back. But there’s a possibility that it would make sense to be more cautious about moving. – Chairman Powell, October 29^th

A more-hawkish-than-expected monetary policy stance will have a direct impact on asset prices via a higher discount rate.

There will also likely be indirect impacts – for example in credit markets, where signs of strain have emerged in recent months. A string of high-profile bankruptcies (i.e., the collapse of car parts manufacturer First Brands and auto loans company Tricolor) have raised concerns about the outlook for credit, with JPM CEO Jamie Diamond warning of more “cockroaches” in hiding.

Markets seem to agree with this concern: stock prices of banks and private equity firms with major private credit businesses have lagged behind the broader equity market so far this year. Investors are cognizant of the risks – BofA’s most recent fund manager survey showed that fund managers view private equity / private credit as the most likely source of a systemic credit event.

Feature: The End of the FOMC’s Quantitative Tightening

Despite these concerns, aggregate default rates in corporate bonds and leveraged loans remain relatively low, suggesting that they do not point to a broad weakening credit quality, with analysts from Goldman Sachs arguing that nothing systemic can be concluded from these idiosyncratic cases.

At its October meeting, the FOMC also announced that it would end the gradual runoff of the Federal Reserve’s securities holdings (i.e., quantitative tightening) beginning on December 1.  The Federal Reserve had been gradually reducing the size of its balance sheet following the plans it had announced in May of 2022.  Under those plans, the FOMC indicated that it would cease balance sheet runoff at a point with reserves still “somewhat above” levels associated with ample reserve conditions.

 Although there had been some signs over recent months of tightening conditions in money markets, many observers anticipated that balance sheet runoff could continue for some time yet. 

Late in August, however, money market conditions began to tighten further with repo rates moving up significantly.  In the period from mid-September to the end of October, repo market pressures contributed to a notable upward move of the federal funds rate relative to the Federal Reserve’s interest rate on reserve balances.  And at the end of October, conditions in repo markets tightened sharply.  Primary dealers turned to the Federal Reserve’s standing repo facility (SRF) for financing, but repo rates still moved well above the SRF rate.  

News reports suggested that President Williams of the Federal Reserve Bank of New York convened a meeting of primary dealers last week to seek feedback on usage of the SRF and to encourage them to borrow from the SRF at times when money market pressures intensify.  The apparent reluctance of dealers to borrow from the SRF could reflect a number of factors including balance sheet costs and also possible stigma of borrowing from the Federal Reserve.  In a recent speech, Roberto Perli, manager of the System Open Market Account, also pointed to the importance of relationships in repo market transactions, noting that dealers and banks may be reluctant to borrow at the SRF in order to provide financing to an unfamiliar counterparty even when rates are attractive.

The end of balance sheet runoff may relieve strains in repo markets in the short-term.  However, this recent experience again raises questions about the resilience of Treasury market functioning in a period of high deficits and high demand by dealers for securities financing.

Government Shutdown Ends but Underlying Issues Remain

The U.S. government shutdown has finally come to an end, after setting the record as the longest in U.S. history. While there was limited economic data released during the shutdown, we know the shutdown impacted consumer sentiment (as shown below, Michigan’s consumer sentiment index fell to a record low). As we will soon likely receive belated economic statistics for September and October, it’s likely the shutdown impacts will show up in other consumer-related economic statistics, including retails sales. The CBO estimates that each week of a government shutdown reduces real GDP growth between 0.1% to 0.2% on an annualized basis, however history has also shown that much of that activity is made up after the government re-opens. It will take some time for it to be clear what underlying economic trends are occurring in data that will in the short-term be impacted by the shutdown and subsequent re-opening, creating further challenges for policymakers.

Despite the resolution of short-term uncertainty about the government shutdown, the longer-term tensions related to fiscal sustainability remain and the fiscal outlook in the U.S. and other advanced economies remains a concern. Importantly, the funding package passed by U.S. Congress will keep the U.S. government open until January 30^th, 2026, at which point we can expect future funding battles, particularly regarding health care tax credits.   

Feature: Japan’s New Prime Minister

The U.S. is not the only economy where market volatility has recently been impacted by shifting political winds and tensions between monetary and fiscal policymakers.

Following the election of Japan’s new prime minister Sanae Takaichi in early October, the yen has continued to weaken. While there are many factors behind the yen’s continued weakness, market commentary has in part focused on whether the new Prime Minister (formerly the Economic Security Minister) will simultaneously pursue an expansionary fiscal agenda and push back on monetary policy tightening. During her leadership campaign, Takaichi called for numerous fiscal spending measures, such as tax rebates for low-income households. At the same time, she has suggested that Japan’s central government and the Bank of Japan work “hand in hand”.

Notably, following the first meeting between Takaichi and BoJ Governor Ueda, Takaichi stated, “The government and the BOJ will continue to work together to advance the national economy,”. Some interpreted these remarks as a sign that the Prime Minister would push back against the BoJ raising rates. Following her comments, the yen reached its weakest level since February.

US-China: Temporary Truce

The U.S. and China reached a trade truce in late October, with the U.S. cutting China tariffs related to fentanyl from 20 percent to 10 percent and China pausing for one year the sweeping export controls on rare earths which had been announced earlier in October. Unlike many other economies, China has meaningful leverage against the U.S., in particular its dominant position in rare earths (~90 percent market share in refining), which are critical inputs into other industries (i.e., defense, technology). As a result, China was able to negotiate lower tariffs, without needing to make the same sorts of investment pledges we have seen from other U.S. trading partners in exchange for lower tariffs.  

China plays a crucial role in global manufacturing, and its dominance is likely to continue going forward. As the right chart below shows, China’s industrial production growth has outpaced the rest of the world. As long as China maintains overcapacity, it will continue to put pressure on the rest of the world. The growing rise in global mercantilist policies is, in part, a backlash over the dramatic expansion of Chinese exports.

One of the other flashpoints between China and the U.S. has been the U.S. current policy of export controls, which seek to prevent the most cutting-edge AI chips required for training AI models from being exported to China (specifically chips from Nvidia and AMD).

President Trump confirmed that he discussed chips with President Xi in October, though he also noted “We are not talking about Blackwell”. It’s been rumored that the U.S. is considering whether to permit sales of Nvidia’s forthcoming B30A chip to China, which would effectively give Chinese AI labs access to AI supercomputers as powerful as those available to U.S. labs, accelerating China’s frontier AI development and arming Chinese cloud providers with the chips they need to compete with American counterparts.

Markets appear to be pricing in quite a bit of optimism regarding Chinese tech companies’ ability to compete with their U.S. peers in advanced technology. Below, we show Chinese tech stocks, alongside the broader market, indexed year-to-date. Note the first increase in tech stocks outperformance when DeepSeek introduced an AI model that drew global attention in late January. Ongoing progress in domestic chip design and Beijing’s instructions to major companies to rely more on domestically produced chips have also likely fueled market enthusiasm in China.  

Despite the detente, this is likely to be a temporary truce in the longer-term confrontation for global technology dominance between the U.S. and China. Tensions between the two economic superpowers are likely to persist, and the tail risk of a significant escalation causing substantial consequences for the global economy cannot be excluded.

Feature: China’s Five-Year Plan

In October, China approved the draft proposal of their 15^th Five-Year Plan, covering 2026-2030. The major goals in the plan highlight why China is set to remain on a collision course with many other economies. China’s Five-Year Plans are government blueprints which outline national economic and social development goals for the next five years. The plan sets specific targets and priorities—such as industrial growth, innovation, and environmental policies—to guide the country’s long-term strategy. This planning approach illustrates the ways in which Chinese policy differs from the US – the planning cycles are longer-term (five-years compared to the four-year US election cycle) and the process is more centralized, with the Communist Party’s Central Committee making decisions for how to guide the states resources and priorities (in contrast with the U.S.’s more decentralized approach).

The first two goals mentioned in the 15^th five-year plan highlight why China will continue to remain in tension with the U.S. and other advanced manufacturing economies:

The first goal mentioned in the plan is to “Build a modern industrial system and consolidate and strengthen the foundation of the real economy” and describes how China will seek to upgrade traditional industries (enhancing competitiveness) and foster industries of the future.

In other words, we can expect a continuation of China’s forceful industrial policies – these policies have helped China achieve global dominance in many sectors (i.e., solar, increasingly EVs) but have also increasingly created tension with other advanced manufacturing economies (European manufacturers in particular have faced mounting pressures from Chinese competitors in the last few years).

The second goal in the plan describes “Achieving greater self-reliance and strength in science and technology and steering the development of new quality productive forces”. The plan focuses on strengthening national innovation capacity through entire-chain innovation in semiconductors, machine tools, high-end equipment, basic software, advanced materials, and biomanufacturing. It seeks to expand application scenarios and improve IP protection.

Here, the U.S. is a key competitor, with AI leadership the most salient arena. China is seeking to lead the world on AI model development and deployment, but is currently constrained as their researchers lack access to leading edge semiconductor chips, as the U.S. and its allies have placed stringent export controls around leading edge chips. China is seeking to develop their own leading edge chip production capabilities but is constrained here as well by export controls on semiconductor manufacturing equipment (SME). How competition in this area will play out will depend both on how the U.S. and allies evolve export restrictions on chips and SME, and also how quickly China makes progress on developing their own SME (where they currently have almost no market share in the most critical advanced tools).