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Today’s Points:

• Markets to rating agencies: You’re overrated.
• The S&P 500 actually gained in response to the Moody’s Treasury downgrade.
• The Rest of the World is still outperforming, thanks in part to a weaker dollar.
• Looks like the Fed is on hold at least until September.
• AND: a compound podcast recommendation.

Moody’s Schmoody’s

Blink and you missed it. The historic downgrade of US sovereign debt announced Friday night only momentarily interrupted momentum. The S&P 500 rose 0.09% for its sixth consecutive daily gain, while bonds had a good day despite Moody’s negative judgment. After an initial selloff, the 10-year Treasury yield closed the day at 4.44%, 3.2 basis points lower for the day.

Treasury Secretary Scott Bessent’s dismissal of the agency as a “lagging indicator” of US fiscal policy looks to have been right. It had no significant short-term impact. 

That said, Moody’s nailed a broader truth — that US debt has surged. Germany’s post-Global Financial Crisis “debt brake” left it with space to borrow now. American debt kept rising and takes a bigger share of the economy than China’s. The chart is by Mansoor Mohi-Uddin of the Bank of Singapore:

Even though Treasury debt is the linchpin of the world financial system, it is now lower-rated than 10 other countries: Australia, Canada, Denmark, Germany, Netherlands, New Zealand, Norway, Singapore, Sweden, and Switzerland. So there are alternatives, even if they’re nowhere near deep enough to soak up all the money in Treasuries. As Europe embarks on extra borrowing to bolster defense — at a stronger rating than Treasuries — there could be more triple-A bonds available to buy, as Deutsche Bank AG illustrates:

Source: Deutsche Bank

The rally shows that the “End of the US” trade was overdone, but the fact remains that overvaluation got so extreme earlier this year that some adjustment was vital. US stocks have recouped only a little of the ground lost to the rest of the world: 

This is in part due to the dollar. The 2011 downgrade by Standard & Poor’s spurred what now looks like catharsis, which then started a decade-long rise. This time, particularly in real terms (accounting for differences in inflation), the dollar looks expensive. Investors didn’t feel over-exposed to US assets 14 years ago. That has changed, suggesting room for the dollar to fall further:

As Deutsche shows, the consistency of the dollar’s overvaluation compared to purchasing power parity (the exchange rate at which goods cost the same in two currencies) is unprecedented. Moody’s judgment is symptomatic of the appetite to bring it down:

A strong dollar is a problem for the US when policymakers are prioritizing exporters’ competitiveness. The administration is wont to complain that the rich dollar is a “non-tariff barrier.” That explains why sudden weakening against some of the Asian currencies that stand to be most affected by tariffs was greeted as evidence that these things are negotiable — and that the underlying direction of the dollar is downward:

Slack foreign demand for Treasuries also weakens the dollar. Foreign bidders don’t participate directly in Treasury auctions, but have their bids placed by intermediaries — hence “indirect.” Apollo Group’s Torsten Slok points out that such participation in 30-year Treasury auctions has trended sharply down recently:

All else equal (it never is, but economists assume as much), higher bond yields would raise the dollar compared to other currencies. But this time, expectations of higher fed funds rates have had no impact of any significance on it. (If you’re reading this on the terminal, try opening this chart in GP to see the two lines on the same chart):

Similarly, the spread of Treasuries over German bunds hasn’t bolstered the dollar against the euro. Again, try opening this in GP:

This relationship is even clearer when comparing real yields, as in this chart from Mizuho’s Jordan Rochester. The dollar is less attractive to foreign investors than a few months ago, for reasons beyond the standard macro drivers:

That implies a further reason for weakness ahead. Manish Kabra of Societe Generale SA suggested that ongoing reduced foreign ownership of US Treasuries meant that the Fed would be be the lender of last resort — and would eventually be forced to ease. “This is why we say ‘Great Rotation for long-term,’ i.e. Fed moves will drive the US dollar weaker.”

China: A Matter of Balance

When Bessent announced the trade truce with China last week, he said that neither side wanted a “generalized decoupling” and stated his belief that “everyone agrees, including Chinese leadership, that they need to rebalance toward more of a consumption and consumer economy.”

It’s hard to disagree, but it’s also hard to discern serious attempts toward that goal by either government. Mallika Sachdeva of Deutsche suggests that if the US and China could really agree on a mutual rebalancing, “this would show up in efforts to narrow the US fiscal deficit, and a willingness to gradually appreciate CNY.” That is a shame. The “big, beautiful” bill now in Congress promises to widen the US fiscal deficit still further, while China shows no enthusiasm to jack up its currency. The rate set by the Chinese authorities is oscillating close to a 17-year low compared to the dollar:

The two sides have, however, pursued different decouplings for more than a decade. China has been steadily reducing its huge holdings of Treasury debt. The latest figures, to the end of March, showed its pile dropping below the UK’s Treasury holdings for the first time since 2002. The scale of China’s holdings has frequently provoked speculation that Beijing could hold the US to ransom. Nobody seems to fear such an outcome from the British:

Meanwhile, as China fails to spark consumers into life and eases money, its bond yields fall. That makes it harder to push the currency up. Most spectacularly, the spread of Chinese over Japanese 10-year yields is at an all-time low:

Market forces (with a little help from the rating experts at Moody’s) are doing what they can to engineer a rebalancing. US and Chinese politicians need to play their part. 

Little Drops of Water

It’s been six days in a row. Last week, both the S&P 500 and Nasdaq 100 recorded perfect weeks, recording gains each day. This is especially remarkable as tariffs-driven uncertainty lingers. The S&P is on its second-longest winning streak in the tumultuous year, while the Nasdaq hasn’t rallied this long since August:

What’s driving this? Bank of America’s Fund Managers Survey showed US equity allocation dropping to a two-year low. That’s evidence that stocks drew their strength from sources other than smart money or institutional investors:

Instead, look to the might of retail investors buying the dip. On Monday, when the S&P 500 initially tumbled 1% in reaction to the Moody’s downgrade, retail investors’ made $4.1 billion in net purchases of US stocks by midday to erase the losses, according to JPMorgan’s Emma Wu. Quite a counterbalance.

Is there more to this mass action? Financial Insyghts’ Peter Atwater believes so, arguing that fiscal and monetary policymakers, at every turn, have responded to the slightest market discomfort with dramatic reactions. That strengthens retail investors’ conviction that the market always recovers (and so you should always buy the dip):

Maybe it is just me, but I think the consequences of the crowd’s now-Pavlovian response are clearest in stock price charts. “U”s have turned into “V”s have turned into bungee jump drops and rebounds in which the retail crowd provides the elasticity to the rope, all but propelling the markets higher once prices reach their nadir.

Do retail investors possess the means to sustain this rally? Perhaps. However, it makes sense to assess their response to last week’s 90-day pause in the US-China trade conflict, which sparked the latest stage of the rally. Northern Trust Asset Management’s Anwiti Bahuguna concedes that the pause was unsurprising, but the share rebound that followed was stronger than had been priced in. Still, she argues against shifting portfolio allocation, now that the pause has happened:

When determining our tactical portfolio positioning prior to the trade talks, we were mindful of the possibility of an upside surprise that we believed would help support equity prices. As such, this played into our decision to trim our US equity exposure to an equal-weight position rather than reducing to underweight versus the benchmark. The trade progress reduces risk of a left-tail economic event for now. But is this the all clear signal? In our view, we’re not out of the woods yet.

Trusting that there’s spring in the rope. (Zhangjiajie in China’s Hunan province.) Photographer: Wu Yongbing/VCG/Getty

Retail investors probably don’t have enough firepower to keep the rally going, so institutional investors will have to join from the sidelines. If there’s a cue to that effect, it lies in the analysis by HSBC Bank’s Duncan Toms, which shows institutional sentiment and positioning still sending the strongest contrarian buy signal since 2022. Despite the historic rally, none of HSBC’s indicators suggest excessive bullishness:

That is also a bullish signal — when we have had this historically, the S&P 500 has outperformed US Treasuries by around 10% over the following three months… For a more persistent fall in the S&P 500 and risk assets, we’d need to enter the Danger Zone — a level of longer end rate expectations we remain a little way away from.

Ultimately, whether smart money joins in the rally or not depends on the Treasury market. In Atwater’s view, intense buying at the bottom, driven by retail investors, is quickly followed by sudden exhaustion. What propels the market is no longer the retail crowd piling in at higher prices, but institutions playing catch-up. “Today, underperformance, not greed, drives professional cashflows,” he says. If Treasury yields break to the upside, it might make a case for hedge funds to stay underweight on equities. He sees a buying panic if rates fall.

The outcome of the tax bill currently under House consideration could be the next game changer. Glenmede’s Jason Pride argues that the “decently large” bill could deliver a “stimulative” impact that would be harder for share institutional investors to ignore. (Although bond investors might also find it hard to ignore, which could be a problem...) 

—Richard Abbey

Survival Tips

A biased podcast recommendation for you. Last week I threw caution to the wind and took part in The Compound and Friends podcast with “Downtown” Josh Brown and Chris Davis, an investor who among other things sits on the board of Berkshire Hathaway. It goes on for about 90 minutes. If you have the time, the relaxed format  allowed us to have a real conversation and go into issues in depth. It was a lot of fun.

More Charts on the Terminal from Points of Return: CHRT AUTHERS

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