US 10-year Treasury yields have fallen by almost 50bps since their mid-April high. The three-month 10-year yield curve has inverted again (currently by 23bps) and the fed funds futures market is pricing in almost three 25bps Federal Reserve rate cuts this year.

An inverted yield curve is often seen as a precursor to a recession, but we think its predictive value may be less than in the past. A prolonged period of accommodative central bank policy, institutional demand for bonds and lower term premiums have suppressed long-term yields, making it easier for the curve to invert. And prior yield curve inversions have not indicated an imminent downturn. Since the 1970s, the 3m/10y spread has inverted four times, and each time the economic expansion continued (on average for 1.75 more years), while stocks rose by an average of 40.5% before the eventual market peak.

In any case, our base case posits long-term yields moving higher and ending the inversion. We doubt President Donald Trump would want to risk entering the run-up to the 2020 election with a slowing economy and weakened stock market, and eventually we expect him to return to a more conciliatory tone. On Mexico, opposition to imposing tariffs has arisen from the business community, parts of the Republican Party and even within the administration itself. In addition, from China's perspective, economic self-interest still looks likely to outweigh nationalist sentiment in our view, as further US restrictions on technology transfer would slow China's progress in developing its IT industry.

That said, we shouldn't ignore the signal from the fixed income market. The plunge in yields signals that risks have risen and that rate cuts are likelier than hikes. It reflects the recent escalation in trade tensions. We estimate a c.30% probability of US-China talks breaking down. And the move in the fixed income market is directionally consistent with more dovish recent commentary from the Fed – St. Louis Fed President James Bullard on Monday said “a downward policy rate adjustment may be warranted soon”.

Given the combination of a positive base case but elevated 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. While we don't advise making explicit trades on the yield curve at this time, given the two-way risk, investors can think about using the period of lower yields to selectively seek carry – preferred areas at present include an emerging market foreign exchange basket (INR, IDR, ZAR), high-quality dividend stocks and green bonds.