One of the key dynamics driving financial markets right now is the relationship between policy uncertainty and credit risk. This can be clearly seen in the correlation between the BBG Daily Trade Policy Uncertainty Index and High Yield CDX spreads.
A recent note from Bank of America highlighted this interplay, projecting further declines in trade policy uncertainty. According to BofA, the uncertainty index could drop by another 50%, reaching the 4.0–4.5 range, and as that anxiety fades, HY CDX spreads are expected to tighten toward the 290bps area. The reasoning? The “Fed-April spread spike” was largely driven by a surge in uncertainty—something now expected to fade—and more fiscal stimulus is starting to get priced in.
BofA: “We expect additional declines in uncertainty in the near term… HY CDX spread is expected to head lower… as fiscal stimulus is priced in.”
Moody’s Downgrade: A Sobering Reality Check
Despite these positive signals on credit spreads, Moody’s delivered a stark reminder of the macro risks: the U.S. sovereign credit rating was downgraded to Aa1 from Aaa, with the outlook shifted to stable. Citing the widening fiscal deficit and ballooning debt levels, the move adds pressure to both bonds and the dollar. The downgrade triggered a “sell America” impulse in global markets, with US equity futures down, and Treasuries under pressure.
Meanwhile, the UK has now overtaken China as the second-largest holder of US Treasuries, a symbolic shift that speaks volumes about ongoing geopolitical realignment.
Positioning: Markets Getting Long Again
On the positioning front, Goldman Sachs Prime Brokerage reported the second-largest weekly notional net buying of global equities in a decade, driven by renewed optimism and momentum in U.S. markets. This “stop-in” behavior—where investors are pulled in by strong performance—is reminiscent of December 2021 levels.
Inflation: A Matter of Politics—or Just Uncertainty?
In a peculiar twist, inflation expectations have become politically polarized. The spread between Democratic and Republican forecasts for inflation 5–10 years out is now as wide as the median estimate itself. The divergence reveals just how murky the outlook remains—even as core CPI data shows signs of stabilizing.
“No one has a clue what inflation will be… or perhaps it’s now a partisan decision.”
Fed Policy: Cuts Postponed
Adding to the evolving macro backdrop, one of the largest U.S. banks has pushed back expectations for rate cuts, now seeing the Fed’s first move delayed from September to December. After that, it expects a gradual easing to a 3.25–3.5% target range by Q2 2026. The message? The labor market doesn’t warrant urgency, and the Fed prefers to let incoming data drive policy.
Bond Market Signals: Long End Stays Anchored
Despite front-end volatility, Citi notes that swaptions markets aren’t pricing aggressive moves at the long end. The 30-year remains relatively anchored, even during sharp sell-offs—a signal that long-term inflation and growth expectations remain subdued.
Global Backdrop: A Mixed Bag
- China: Retail sales disappointed (5.1% vs. 5.8% est), though industrial production beat expectations. Property remains a drag, with residential sales down 1.9% YTD.
- Europe: The EU Commission slashed its 2025 growth forecast to just 0.9%, citing trade tensions, U.S. tariffs, and climate-related disruptions.
- UK-EU relations are warming, with a new agreement aimed at post-Brexit reconciliation, while UK house prices showed signs of a modest rebound.
Final Word: Navigating the Dollar “Fiscal Frown”
As Deutsche Bank notes, we may be entering a “fiscal frown” dynamic in FX and bonds. At one extreme, loose fiscal policy risks a loss of investor confidence—dropping both the dollar and Treasuries. At the other, tightening too quickly could induce recession and force aggressive Fed action. The middle path? That’s the most elusive of all.
In short, while policy uncertainty may be falling, the structural challenges facing the U.S. economy—fiscal imbalance, political polarization, and a now-downgraded sovereign rating—remain.
Markets may rally on relief, but risk never truly disappears. It just rotates.
IBAFIN 
Leave a comment