Inflation/Deflation

The Fed's recent dovishness represents an acknowledgement of the feedback loop between Fed policy and financial conditions. Expect Fed hawkishness to ramp back up prior to the next rate hike, likely in June.

The Fed's decision to scale back intended interest rate hikes reflects economic reality.

A Chinese reflationary cycle is unfolding. Capital spending is showing signs of regained vigor, driven by both housing and infrastructure. Chinese PPI deflation will ease further. This will help reduce balance sheet stress of materials producers and boost overall industrial profits. Remain positive on Chinese investable stocks.

The current uptrend in Treasury yields will be cut short once the dollar appreciates in response to an increasingly hawkish Fed. Maintain benchmark duration and add a long 2/10 barbell, short 5yr bullet trade to profit from Fed hawkishness.

Bearish sentiment, higher oil prices and Chinese policy stimulus leave room for a continued bounce in stock prices. But this rally is unlikely to prove sustainable.

The relief rally is not over, and could benefit from commodity and currency market movements. Oil prices likely are banging out a bottom. In general, however, a healthy dose of caution is warranted. Our bias is to sell into, rather than chase, rallies in risk assets.

Inflation expectations in the Developed Markets have been adjusting down to the lower trend of actual inflation, although the bulk of this adjustment now appears complete.

Credit growth acceleration in China is a bearish development in the long run. Potential non-performing loans at Chinese banks could wipe out 40-55% of their equity capital. "Muddling through" for China, from its own internal standpoint, is possible. However, Chinese stocks and China-related equities worldwide will remain in a bear market. From the perspective of the rest of the world, China is now in recession.

A near-term rally in risk assets now appears very likely. But we expect it to be cut short when the Fed eventually reacts to easier financial conditions by returning to a more hawkish policy stance. Investors should maintain a defensive portfolio allocation on a 6-12 month horizon, and remain overweight TIPS versus nominal Treasuries.