One week / one topic: The three-body problem

What happened?

Three top policymakers, three agendas – something’s gotta give…

The tension between the top US political, economic and monetary establishment is increasingly impossible to ignore:

• President Trump has been extraordinarily active, both militarily (Venezuela, Iran, Cuba?) and fiscally (sweeping trade tariffs to finance the One Big Beautiful Bill).

  His administration continues to run deficits near 6% of GDP at full employment, with above-target inflation and decent growth — a combination "never before seen in peacetime" – pushing US long yields to two-decade highs.

• Treasury Secretary Bessent arrived on the scene promising 3% growth, 3% deficits and an extra 3m barrels of oil per day.

  The scoreboard says 2%, 6% and N/A respectively, and in turn he has lately become increasingly interventionist.

  He can call recent actions "liquidity support", but the market instantly read it as price management — and reacted accordingly.

• Fed Chairman Warsh, meanwhile, wants to say as little as possible and let markets "do the Fed's work for them" (see recent editions). Laudable in theory, perhaps…

  In practice, his approach has twice produced monumental — and opposite — curve moves, with investors still waiting for a credible plan to bring inflation back to target after five years of overshooting.

There you have it, then: a president who wants low rates to keep spending, a Treasury secretary who needs low rates to keep financing, and a Fed chair who prefers to keep quiet but still has an inflation problem to fix. (see Jackson Hole remarks)

Three bodies, three gravitational pulls.

As any physicist will tell you, a three-body system is chaotic and has no neat, general solution.

How should we position portfolios in this environment, then?

Our observations

• Fundamentals: Trump's activism raises term premium and inflation risk; Bessent needs it lower; Warsh's mandate is price stability, not deficit financing.

  The pen is indeed mightier than the sword, but we might be running out of creative ideas to manage such a fragile system.

• Price action: In short order, we have reached 19-year highs in 30y yields and saw a Treasury “twist” that evaporated within a day, with gold breaking out and the dollar sliding to a three-month low.

  Hard to miss…!.

• Investor beliefs: Inevitably, the more the US Treasury is seen as defending a price, the more markets will test it.

  Stan the Man warned us that “governments defending prices against fundamentals always lose” – pay attention..

So what?

In the end, something must absorb the strain – and the US dollar looks like a good candidate.

Inflationary pressures have persisted for years and the full faith and credit of the US government keeps getting undermined – no wonder that the dollar’s status as a stable store of value is being chipped away.

Emerging economies and their central banks have managed the Covid crisis and subsequent inflation surge much better than developed markets counterparts, and also sport much lower debt levels.

Currency returns reflect this, and one is increasingly left wondering how much the gap between EM and DM has shrunk… and if indeed there is now some overlap.

Putting it all together, we have rebalanced our exposure to EM by reducing concentration to Latin America and opening positions in Czech and Polish bonds.

The bias it to increase positions in this space, but then again let’s not get carried away just yet?

Mood music: The Beatles – Across The Universe

By popular demand, here is the One week / One topic playlist

The information provided should not be considered a recommendation to purchase or sell any particular security.