The purpose of this article is to focus on what markets are doing, rather than what they should be doing.

At this point, it is quite clear that markets in summer 2022 have not followed the usual script of boring, sideways trading. Instead, they have rallied, with many folks eager to move on from the bearishness of 2Q22.

Broad US equities have retraced about 50% of those losses over July and August, while seemingly unstoppable Dollar strength has also eased off somewhat. Dr Copper, often looked to as a key leading indicator of the economic future, has rallied strongly over the same period as well.

Does this mean that everything is rosy?

Here is where the subtleties and details in two of the world’s most important markets matter.

1. USD

The USD is the world’s reserve currency, which makes the availability of Dollars in the global financial system the world’s de facto money supply.

If this statement does not make sense to you, or if you immediately dismiss it as inaccurate, you probably believe the Fed controls the supply of USDs; but it doesn’t. See here for how money is really created.

July and August saw the USD move off its highs, against both Developed Market (DM), and Emerging Market (EM) currencies.

However, instead of rallying further in tandem with US equities, the USD has traded sideways through the first 2 weeks of August, and has begun to strengthen against the biggest underperformers of the year, DM currencies like the EUR, GBP, and AUD.

Taking a deeper dive into currencies, we see that the key USDCNY pair is screaming loud warnings. The CNY spent the entire July – August period gradually weakening against the USD, which we discussed previously here.

That gradual weakening has now accelerated, with the CNY decisively moving out of its range against the USD.

Clearly, the supply of Dollars around the world is tightening, and has been for the past 12 months. More importantly, the rally in US equities does not, and cannot change this fact.

Charts and key levels on the currencies mentioned above can be found in our latest Macro Edge report. 

2. US Treasuries (USTs) 

The Dollar isn’t alone in indicating that general optimism based on the rally in US equities might be overblown. The US yield curve is another crucial global market loudly saying otherwise.

It is now deeply inverted across multiple points:

• 2s-5s at -18 bps
• 5s-10s at -14 bps
• 2s-10s at -32 bps
• 2s-30s at –7 bps

The depth and breadth of the inversion across the mid and long end of the curve demonstrates clearly that markets are very concerned about the lack of growth driven inflation, and that high levels of stress exist in the global financial system.

This is confirmed in the US TIPs market, which is now pricing in levels of 5y and 10y inflation (breakeven rates) that are way off its highs for 2022.

Also, US yields, especially at the long end, have come down from the highs they made in June. Yields on the 10y and 30y have come down but not crashed, even though the CPI is still running way too high, and the Fed is still loudly hawkish. 

If clearly telegraphed Fed tightening, and persistently high levels of inflation in the real economy cannot keep long yields and breakevens near their highs, something is very wrong.

Not just in the global economy, but also with the worldview that believes in the Fed’s omnipotence.

In short, the probability of yields crashing is not zero, and the UST market is not a fan of the rally in equities.

Updates, charts, and key levels in the 10y, 30y and US yield curve can be found in our weekly Macro Edge reports.

If you would like to learn more about how the global financial system really works, how the key USD and UST markets fit within it, and a trading framework built around this perspective, check out our course on how to make money trading a crisis.