Market Update: Weak links in the outlook

After a roller coaster week, markets end just a bit lower than when we started. Equity indices were mixed in their own currency terms. US investors will see their markets as slightly down, but US returns will look worse for international investors, thanks to another slip in the US dollar.

Donald Trump threatened to invade a NATO ally and impose sharp tariffs on European nations – only to back down in exchange for a vague framework of a deal, and some mining contracts offered as tribute. Markets sank on the tensions then recovered when they cooled. We write more about Greenland and Europe’s response separately.

On the bright side, it looks like the TACO trade (Trump Always Chickens Out) continues to protect against downside risks. But having to rely on such mechanisms can make the extreme look normal. TACO’s return should not be taken as investors saying everything is fine. Several market signals suggest that geopolitical tensions are taking a toll – most notably the weak dollar. We remain bullish on the global growth outlook, but the Greenland episode has laid bare some weak links.

Treasury weakness isn’t Made in Japan

US government bond yields rose quite sharply as Trump ramped up his Greenland threats. It was disappointing to hear Treasury Secretary Scott Bessent lay the blame elsewhere. Supposedly, the US yield move was caused by a sharp move up in long-term Japanese Government Bond (JGB) yields. On Monday, 40-year JGB yields broke through 4% for the first time ever, sending shockwaves across global bond markets. Regular readers will know we are positive on Japan, so how does that stack up with bond market drama?

We should point out that the long-maturity JGB market is notoriously illiquid. It is dominated by large Japanese insurance companies, who have to hold long-term bonds for a variety of regulatory and risk-management reasons. Oddly enough, Japan’s recently strong economic growth and stock market performance has lessened the need for insurers to hold as many long-term JGBs. That lessened a key source of JGB demand in an already illiquid market, meaning even small selling pressures – following Prime Minister Takaichi’s tax cut plans – can cause a sharp sell-off in longer maturities.

This is similar to the UK bond market’s ‘Liz Truss moment’. Just like the UK market in 2022, we expect there will be eager buyers for historically cheap JGBs. We know some of them personally. Although yields came back down quite quickly after the Truss episode, it exposed a structural imbalance which is still being resolved. JGBs could trade at a relatively ‘cheap’ level for some time as well.

However, Scott Bessent is wrong to say US bond trouble is made in Japan. We can clearly see a rise in the risk premium for US 10-year treasury bonds relative to the small move in 10-year UK Gilts, German Bunds and even the Japanese 10-year government bond! The dollar also weakened and, unlike US stocks, it did not recover once Trump relented on Greenland. We saw the same dollar pattern after last year’s ‘Liberation Day’ tariffs. Since then, dollar weakness has been a clear US policy risk signal.

The bond fundamentals are changing too

Aside from the political drama, there has been a slow deterioration in US underlying bond fundamentals. Through the past few weeks, rising wage pressures are appearing, while supply chain problems and the weaker dollar are pushing up input prices. That suggests inflation will no longer keep falling, meaning higher interest rate expectations and higher long-term yields.

At the same time, private sector credit demand looks a little disappointing. We had expected US credit issuance to remain strong this year – thanks to tech companies spending big on AI infrastructure – but it looks like money demand is highly sensitive to interest rate expectations. Consumers are saving more too. The US government could take advantage of weak private sector loan activity by borrowing and spending more itself, but that would raise US yields further. We nevertheless expect the administration to do so, given Trump’s need to improve his party’s popularity ahead of the midterm elections in November.

The US will not be alone if it boosts fiscal spending; Europe and Japan are set to spend too. The UK is the one exception, with the government still signalling fiscal discipline, albeit through higher taxes rather than spending less. That policy is reducing the monthly deficit, with a 38% year-on-year fall in December. Many investment professionals do not think this will last. UK bond traders seem to expect a loosening of fiscal policy – perhaps prompted by a change of Labour leadership – after May’s local elections.

Weak links emerge

The Greenland fracas was not the only dynamic weighing down European assets this week. After a strong run, several equity strategists and analysts have downgraded their outlooks for European stocks. This is partly about the strength of the euro (making European exporters less competitive) but the sharp move up in energy prices is also biting.

Futures contracts for European natural gas moved up sharply over fears that the US administration might embargo its shipments of liquified natural gas to Europe. Since Russia invaded Ukraine, Europe has replaced its Russian gas dependency with an American gas dependency. Commodity traders suspect that Trump may have little compunction in imposing a form of sanction as well.

Gas prices stayed elevated even after Trump backed down on his Greenland threats. We see this as another sign – alongside dollar weakness – that geopolitical crises leave scars, even if not much changes in the short-term.

Washington’s confrontational start to the year has shone a spotlight on the vulnerability of the 2026 investment outlook. Global growth should be strong, but it comes with risks and higher yields and gas prices are certainly two of the significant ones. US and global bond yields might not fall as many expected them too – regardless of what happens to interest rates. Markets could really do with a period of political calm. But, with Trump saying that another US government shutdown is likely at the end of this month, we will not hold our breath.