The threads of the markets continue to weave a complicated story. The landscape has moved from a backdrop characterized by a hawkish Fed, a bulletproof AI investment cycle, and a willingness to look through Iran/U.S. tensions, to one defined by a respite from Fed tightening, doubts about the return on investment of AI spending, and a renewed Iran/U.S. conflict with no end in sight.
Inflation and the Fed: A Temporary Reprieve
Inflation prints have surprised to the downside recently, which takes the risk of an immediate rate hike at the July FOMC off the table. Last week’s CPI and PPI readings printed below most expectations, providing a reprieve from the worrying inflation dynamics that emerged following the March energy shock. CPI fell month-over-month in June, the largest monthly decline since April 2020, and is now tracking at 3.5%, down from 4.2% in May. PPI also declined by 0.3% in June and slowed to 5.5% on a year-over-year basis from 6.0% in May.
The decline in headline CPI and PPI was expected given lower energy prices in June. More encouragingly, shelter inflation, a major contributor to core inflation that has little to do with energy prices in the near-term, rose by only 0.1% in June, the smallest monthly increase in six years.
Markets continue to price a benign inflation outlook, even if recent geopolitical developments have increased uncertainty at the margin. One-year inflation swaps imply inflation of just 2.02% over the next year, suggesting investors expect the Iran-related energy shock to remain contained and elevated current prices to fade through base effects. A July FOMC hike appears unlikely, as markets are implying only a 14% probability.
With policymakers offering little in the way of explicit forward guidance, each economic release carries an outsized influence. August’s inflation report therefore has the potential to shift expectations back toward a September hike, or price hikes out entirely if inflation continues to surprise to the downside.
Geopolitics: The Inflation Wildcard
Meanwhile, the conflict between the United States and Iran shows little sign of resolution, while uncertainty remains around the potential scope of future U.S. involvement. The most visible manifestation of geopolitical uncertainty has been a higher energy risk premium.
While oil markets have remained orderly thus far, the range of possible outcomes has widened meaningfully, creating another potential source of inflation volatility just as the Federal Reserve seeks confidence that price pressures are moving sustainably toward target.
AI: The Growth Narrative Faces Scrutiny
While the Fed narrative has received a temporary reprieve, another risk has emerged in the form of cracks in the AI infrastructure theme. For the better part of four years, investors have embraced the assumption that massive AI-related spending would justify itself through productivity gains and future growth.
Hyperscaler capital expenditures are approaching levels that could represent roughly 2% of U.S. GDP, with much of future investment being financed through the debt markets. Recent debates around corporate IP sovereignty and the rapid advancement of open-weight models have prompted a closer examination of the economics underpinning AI-related capital spending.
Implications for Markets
Rates
For rates, the combination of limited forward guidance and an unpredictable geopolitical backdrop creates scope for significant moves in either direction. Shifting expectations around Fed policy have been the primary driver of rates this year, and that dynamic is likely to persist, especially under a Warsh regime.
Credit
Credit markets face a different challenge, as the AI investment boom has become an important pillar supporting optimism in corporate fundamentals and economic growth, which then influences systemic credit conditions. Spreads remain priced for favorable conditions broadly, leaving little room for disappointment if the narrative begins to crack.
While the broader credit market has absorbed idiosyncratic credit events well this year, hyperscaler bonds have started to diverge from the pack in an unfavorable fashion. Record issuance and aggressive investment plans have influenced spreads to drift wider as investors grapple with the sheer scale of AI-related capital spending.
It remains to be seen whether this widening represents a temporary supply digestion or the early stages of a broader macro reassessment. As capital continues to concentrate around the AI buildout, diversification becomes increasingly valuable in a market where both valuations and credit spreads leave little margin for error.
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