The Fed flattener. The FOMC’s continued gradual rate hikes should keep the US curve on a flattening trend. This should offer little support to the USD. US data this week continue to suggest that growth is slowing back toward trend after peaking in Q2, consistent with market pricing of a terminal rate near 3%. Long-end yields will likely struggle to outpace higher short rates in the absence of material productivity gains, and USD should struggle to find support accordingly.

Inflation is the key risk... Inflation is a key risk and markets do not appear prepared. US 10Y breakevens are almost unchanged from February despite firming wages, core inflation, and energy prices. This is not just a US story – German inflation is near 5-year highs and President Draghi reaffirmed his confidence in rising core inflation. Investment in many cases is failing to keep pace with increasingly tight capacity, a topic we explore this week in detail, which creates further inflation risks.

…and can drive volatility. Higher inflation may force central banks to abandon gradualism, leading to higher real yields but also market volatility as monetary authorities seek to slow demand to blunt inflation pressures. The resulting tighter monetary conditions and funding costs suggests those economies most reliant on foreign inflows and those banking sectors most sensitive to USD wholesale funding costs are the most vulnerable. AUD clearly stands out here. Surplus currencies like EUR, JPY, NOK, and SEK should outperform and we trade accordingly. CAD looks vulnerable to NAFTA concerns.

Phoenix rising: EM is recovering after a prolonged sell off. We removed our bearish stance on Monday and are long RUB, ARS and IDR. Positioning coming into September was defensive and while this is likely changing we think EM can continue to perform well in the near term. We remain cautious about the durability of the rally, though, given extended valuations in DM assets and expectations for further escalation on trade issues.

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