The S&P 500 rallied by 2.1% on 4 June after Federal Reserve chairman Jay Powell said that the central bank was closely monitoring the impact of trade negotiations on the economic outlook and would act “as appropriate” to sustain the expansion.

But we would caution against reading into Powell’s comments and the stock market reaction that a Fed rate cut is imminent:

* Powell didn’t promise a rate cut. He offered instead a description of how the Fed conducts policy. The market impact of his words may have been strengthened by prior comments from St. Louis Fed President James Bullard, who said on Monday that “a downward policy rate adjustment may be warranted soon”. But Bullard appears to be the only FOMC member to hold this view at present. For example, Chicago Fed President Charles Evans on Tuesday said, “The market pricing for Fed cuts suggests the market sees something that I haven’t yet seen in the national data”.

* At its May meeting the Fed expressed satisfaction with the strength of the economy. The economic data would have to deteriorate significantly to prompt a rate cut, and Fed changes of direction tend to take months. Patience works in both directions.

* The market reaction also probably reflected greater optimism over the US dispute with Mexico after Mexico’s Foreign Minister said that there is an 80% chance that the two countries will find common ground. Overnight, however, President Donald Trump said that his plan to impose tariffs was “no bluff”. While we don’t see a rate cut in the near term, the recent slump in yields reflects the escalation in trade tensions. We should not ignore the signal from the fixed income markets that risks have risen and that rate cuts are likelier than hikes. If trade tensions escalate further, lowering growth and increasing the risk of recession, the Fed would likely be pushed further toward a cut.

Our base case remains for a trade deal to be reached eventually and for long-term US yields to move higher, ending in the process the yield curve inversion. Given the combination of a positive base case but greater risks, our overall six to 12-month tactical positioning continues to overweight equities but with a regionally selective approach. We also recommend countercyclical positions to help protect portfolios from downside risks, including exposure to the Japanese yen. Investors can further think about using the current period of lower yields to seek carry selectively – preferred areas at present include an emerging market foreign exchange basket (INR, IDR, ZAR), high-quality dividend stocks and green bonds.