Is it time for that four letter word?

An excerpt and link to our weekly comment from Quilter Cheviot

Market overview

Is it time for that four-letter word? To avoid any confusion, the four-letter word (or rather acronym) is TACO (Trump Always Chickens Out). Quick TACO reminder: when markets react badly to one of the US President’s policies or simply one of his social media posts, Trump backs down — think the so-called Liberation Day tariffs in April 2025 or the threat of a tit-for-tat trade war with China in autumn 2025. So, why might markets be in need of a TACO once more?

The Middle East conflict. Hostile action and rhetoric between the US and Iran are on the rise. This, coupled with attacks on energy infrastructure in Saudi Arabia by Iran-backed Houthi rebels who have also seized a large area of the Red Sea coastline, has driven oil prices back above US$100 per barrel. With no obvious off-ramp in sight, inflation worries are once more weighing on sentiment. The higher-for-longer inflation narrative is gaining momentum, and global bond markets have taken note.

All eyes on the 10s…

30-year US Treasuries were in the spotlight a few weeks ago when yields reached 5.34% due to a mix of inflation and debt concerns. The focus is now turning to the 10-year Treasury as the yield approaches the psychological 5% level for the first time since 2007 (aside from a brief visit in 2023). 5% is just a number but markets tend to like round numbers. More tellingly, 10-year Treasury yields directly influence the cost of mortgages and corporate borrowing. So, regardless of the 5% barrier being breached, the fact that yields are now 80 basis points higher year-to-date (YTD) means they are adding to cost-of-living pressures. What’s more, 10-year yields are the risk-free rates analysts use when valuing companies via discounted cash flow analysis. Higher risk-free rates translate into lower company valuations. US Treasury yields are globally significant too as they are key benchmark rates for UK and European bonds.  Little surprise then that the 10-year yield is attracting attention.

…And the Fed

Escalation in the Middle East (and the effect this is having on inflation expectations) is one of the reasons why markets are pricing in an almost 90% chance that the Federal Reserve (Fed) will raise interest rates when it meets this week. So too, was Friday’s August consumer price index (CPI) print. Year-over-year (YoY) inflation was unchanged at 3.4% but the feeling in the market was that unless enough of a slowdown was seen, Fed chair Warsh and co would likely raise rates.  The problem for Warsh is that Trump wants rate cuts. And yet, if Warsh does not deliver a hike, the Fed’s credibility would likely take a knock. Who would be a central banker, particularly one appointed by Trump?

Bond markets need to see the inflation question being tackled. If the Fed decides not to raise rates in September (could the upcoming midterms provide the cover to take no action?) then it may fall to a TACO to do the heavy lifting and settle bond markets. A Trump social media post claiming one big, beautiful peace deal is imminent, or something similar, perhaps? For rising cost-of-living pressures are on Trump’s mind. Witness his comment that soaring diesel prices are nothing to do with the Iran war but down to Ukraine targeting Russian refineries— US diesel prices have breached US$6 per gallon, not far off double the average of US$3.71 a year ago.

The trouble with the TACO theory

Historically, TACOs have tended to follow steep falls in US equity markets. Buoyed by artificial intelligence (AI) stocks, global stock markets have so far largely shrugged off rising inflation concerns and higher bond yields. Of course, that means if doubts over the AI trade were to emerge then stock markets could well lose a key driver behind their resilience.

With impeccable timing, concerns over the sustainability of the rapid pace of the roll-out of data centres as well as the development of frontier models came to the fore last week. Prominent figures from within the AI industry have called for a slowing in the pace of development and for controls to be put in place to tackle safety concerns. Any suggestion that the AI trade might shift down a gear is not what stock markets want to hear. Cue technology stocks starting the new week on the back foot.

The missing ingredient

There have been slowdown calls before (albeit not from the industry itself) and these have had little long-term impact. And it is worth noting that even if model training and rollout eases, the pace of change is still likely to be fast. Inference is one area that remains in short supply so, even if the pace does slow, company revenues are unlikely to be impacted.

That said, there are many moving parts at play here and the wider market will need to get more clarity on the path for AI spending before it can make progress between now and year end, especially at a time of rising interest rates. But here’s the thing, if stock markets struggle from here to year end, then that could well be the final ingredient that goes into creating the conditions for yet another TACO.

Weekly market moves:

The MSCI All Country World Index (MSCI ACWI) ended the week 0.9% lower (+14.1% YTD)…

The value of your investments and the income from them can fall and you may not recover what you invested.