Market Update: Volatility drops but uncertainty remains

We headed into the long Easter weekend with calmer markets than a week ago – but without any strong rebound. Time off from the tariff drama has helped the mood and eased last week’s liquidity concerns, but there still is not much to get excited about. Better than expected profits from microchip manufacturer TSMC boosted tech stocks, though that was counterbalanced by the earlier news that the US will effectively ban sales of Nvidia’s H20 chips to China.

Maybe the calm is more a sense of exhaustion among market participants, and the anticipation of a few days away from the mayhem. Although we welcome the return of liquidity, no one is under the illusion that things will be easy from here.

Bond markets are calmer, but treasuries are still vulnerable. 
The week’s most comforting development was falling government bond yields. Last week’s spike in US treasury bond yields threatened to turn the tariff sell-off into a proper liquidity crunch, but bond buyers returned after Trump’s capitulation. Bond markets’ prevailing narrative is now back to what it was at the end of March: tariffs and policy uncertainty will be negative for economic growth, meaning lower inflation and, ultimately, a lower ‘risk free’ rate of return.

This was helped by comments from the Federal Reserve’s Governor Waller, who declared tariff inflation “transitory” and suggested they could force the Fed to cut rates to support growth – with higher tariffs necessitating sooner or deeper cuts. It would be a stretch to call that warning good for equities, but looser Fed policy would support markets and the global economy. Unfortunately, Fed chair Powell seemed to pour cold water on Waller’s suggestion on Wednesday, when he suggested policymakers needed to wait and see the inflationary impact of tariffs.

On Thursday, the European Central Bank cut interest rates by 25 basis points, as fully anticipated. Despite the ECB’s dovishness, the euro has considerably strengthened while the dollar continues to weaken. That is the opposite of what you would normally expect, and perhaps reflects stronger growth expectations for the continent. The relative positioning of European bond yields (higher yields for longer maturities) backs up this growth forecast, powered by Germany’s fiscal expansion.

We welcome calmer bond markets, but there are two elephants in the room.
The first is Jerome Powell. The Fed’s wait-and-see approach led to Donald Trump explicitly arguing “Powell’s termination cannot come fast enough!” The Supreme Court is due shortly to rule on recent attempts to fire other heads of government agencies and, if they back the administration, investors will question whether the Fed will be independent enough to fight inflation.

The second is China. The week before last’s treasury selloff was triggered by fears that China might sell its vast reserves of US bonds. That did not happen, but the threat has apparently done nothing to deter the White House’s antagonism towards Beijing. Washington announced a restriction on the sale of Nvidia’s specially designed AI chips to China – which will reportedly cost the chipmaker $5.5 billion. Beijing will have to respond in some way, and selling its US treasuries is the nuclear option. Using that option benefits no one, but it becomes more likely the worse that US-China relations get.

Falling volatility helps stabilise markets. 
Lower bond yields mean higher bond prices, which means greater liquidity for markets overall. That has also helped corporate credit spreads (the difference between corporate and government bond yields) come down from the week before last’s highs. There has been lots of recession talk recently, but credit stress is the clearest sign of recession – and we are not seeing it yet.

This has gone hand in hand with a drop in markets’ implied liquidity pricing – measured by the VIX index. This index tracks the cost of insuring your stock positions against potential losses, and hence reflects how volatile investors think markets will be. The VIX’s fall last week makes sense: insuring your equity positions a month ago would have been money well spent, but Trump’s 90-day tariff delay is probably a good time to assess if the insurance premium is still worth it.

We should not overstate this, since implied volatility is still higher than average. But lower volatility, if only slightly, is a sign that last week’s liquidity squeeze has loosened. All else being equal, that should mean investors are more willing to take on risk, and hence will be more likely to buy risk assets.

Some of that buying potential came good into the end of the week, following the earnings release of Taiwan Semiconductor Manufacturing Company (TSMC). TSMC’s profits for the first quarter of this year were 60.3% higher than a year earlier – comfortably beating analyst expectations. Aside from unspectacular mobile chip performance, global tech stocks were cheered on by the results. They showed there is still life left in the AI boom, despite the tariff noise.

But economic outcomes are still highly uncertain. 
It is important to remember that lower implied volatility is an expectation that future price changes will be less sharp, but that does not guarantee markets will actually be less volatile. Similarly, more liquidity in markets will not necessarily find its way into riskier assets. Other indicators of risk appetite paint a different picture: gold prices – the stereotypical ‘safe haven’ asset – reached a new all-time high last week.

Investors can have all the liquidity in the world, but they will only use it to buy stocks if they expect profits. Trump’s policy chaos chips away at that long-term profit outlook. Even TSMC acknowledged in its report that it had little way of knowing whether surging demand was due to people rushing to buy ahead of tariffs – which would suggest weaker profits in the future. And other tech companies have shown a weaker picture, including disappointing earnings from Dutch chipmaker ASML. Overall, the quarterly earnings releases so far suggest that US policy uncertainty is bad for the bottom line. That hurts equity valuations, which are still historically high in the US, due to years of outperformance.

Still, not knowing what will happen does not mean the worst will happen. Indeed, there are encouraging signs hidden in the latest economic data, like the resilience of consumer demand across the world, and the easing of UK and European inflation. It is also good to see more internal sources urging Trump to ease up the policy disruption – which he ultimately caved to last week. Investment professionals are exhausted by the White House’s perpetual revolution. Many in the US now feel the same.