Risks assets continue to rally and bond yields to decline on hopes of Federal Reserve rate cuts. The S&P 500 rose 1% to close at a new record high on Thursday, while at one point 10-year US Treasury yields dipped below 2% for the first time since November 2016. Since early May, US two-year yields have dropped almost 60 basis points (bps) and Fed funds futures are now pricing in more than 100bps of rate cuts by the end of 2020.

Bond markets appear to be signaling an economic slowdown, while equities suggest growth will continue in a low inflation "goldilocks" scenario. These seemingly contradictory stories only make sense if the bond market is pricing pre-emptive Fed rate cuts and the equity market is pricing that this action will succeed in preventing a slowdown. Since 2009, the Fed has proven generally successful at pivoting the right way, but we are wary of positioning for perfection.

* The decision whether to cut rates in July is finely balanced. The Fed’s new summary of economic projections (SEP) suggest the FOMC is almost evenly split between cutting and keeping rates on hold this year. Fed language has shifted from “patient” to “closely monitoring”, which puts it back into data-dependent mode, but also makes it easier to cut rates. On balance, we expect that, if the US data does not change meaningfully, the Fed is likely to cut rates at the next meeting in order to show a commitment to avoiding recession. At last week’s FOMC press conference, Fed chair Jay Powell also lent support to the idea that a larger cut might be appropriate under current circumstances.

* We expect neither a breakthrough on trade at the G20, nor the US to immediately implement another round of tariffs. Our base case is that the meeting between presidents Trump and Xi at the G20 leads to a prolonged truce between the US and China and to continued negotiations. However, given the recent sharpening in rhetoric and the use of so-called entity lists, we assign a 35% probability to a scenario that results in additional tariffs and risks spiraling beyond tariffs. In the risk case, we expect US equities could drop by 10%-15% and Chinese stocks by 15%.

The July FOMC meeting and developments in US–China talks following the G20 summit, which will help inform the Fed’s decision, are likely to be pivotal turning points for markets in the second half of 2019. Given the uncertainty associated with each event, we try to position for divergent potential outcomes. To benefit from a more dovish Fed we are tactically overweight equities with a regionally selective approach, and overweight carry through a basket of high-yielding emerging market currencies against a basket of lower-yielding G10 currencies. Also, in our FX strategy, we take exposure to the Norwegian krone – one of the few currencies in the world with a rising interest rate. We position for the risk the Fed disappoints expectations with a preference for stocks and cash over shorter-maturity US government bonds. We also include a number of counter-cyclical positions to protect against the risk of a breakdown in talks between the US and China at the G20 summit.