Tim Graf: This is Street Signals, a weekly conversation about markets and macro, brought to you by State Street Markets. I'm your host Tim Graf, Head of Macro Strategy for Europe. Each week we talk about the latest insights from our award winning research as well as the current thinking from our strategists, traders, business leaders, clients and other experts from financial markets. If you listen to us and like what you're hearing, please subscribe, Leave us a good review, get in touch. It all helps us to improve what we offer. With that, here's what's on our minds this week.

After a holiday hiatus, Street Signals is back and ready for the second half of the year, or whatever's left of the second half of the year. You get the idea. This summer, as I did around this time last summer, I'm going to do a solo podcast. No guest, just my dulcet tones for 15 or 20 minutes talking about three big picture topics for markets that are most worth keeping an eye on for the remainder of the summer. All of which is viewed through the lens of our suite of proprietary indicators of investor behavior, inflation and media sentiment. We'll talk about where we've been, where we're at, and take a view on where things look most likely to go.

And I'm going to do it with a series of questions, the first one of which is whether or not the rally in risk assets that we've seen taking stocks all the way back to all-time highs in recent days is sustainable and what conditions are needed for that to continue now. After the volatility we saw in markets following the initial announcements of tariffs on US trading partners in April, the knee-jerk swings in sentiment and price were really something to behold. Equity analysts who had previously predicted another year of double digit returns for stock markets, they quickly revised those forecasts lower in April, only to revise them all up again over the last month. There were some absolutely classic cases of mark to market bias here, with some analysts lowering their estimates by as much as 20 percent within a few weeks of Liberation Day, only to very quietly move those forecasts back to the exact same level where they originally were just last month. It sometimes makes you question the value of the profession, but kudos to our own team who actually never really wavered in their conviction that global stocks and US Stocks in particular were still the best asset allocation preference out there in an environment of potentially rising prices, higher volatility and especially in their conviction that the 10 percent local currency underperformance that markets did see in US stocks relative to Europe would eventually close. Which it basically now has.

The rest of the sell side would have been very well advised to track our measures of investor behavior, which did, to be fair, indicate some concern during this episode. Our benchmark barometer behavioral sentiment did deteriorate, but it did not reveal any sense of panic.

In fact, the position reductions that we track in aggregate institutional flow and holdings began before the Liberation Day tariffs sentiment actually first turned NET negative in mid-March, three weeks before the April 2 announcement of tariffs. And the position reduction we saw in US equities in absolute terms and relative to Europe began in early December and it ended in mid-March, which is exactly the period when US underperformance in price terms took place. It was actually all over by Liberation Day.

So what happened? Why are things so much better now?

Well, I think we all learned, or maybe relearned the valuable lesson that the US political economy under the presidency of Donald Trump is all subject to a negotiation process.

His maximalist opening bids rarely are the final state. Trump doesn't always chicken out, but he does try to grab attention with his terms before gauging the waters and retreating to some middle ground. Corporates took advantage of this in talking down their outlook to a dramatic degree, and now the not as bad reality that looks to be taking shape does offer opportunity for upside surprises and to beat lowered earnings estimates. And earnings themselves have come in pretty well. The all-important tech sector looks set to meet or beat expectations yet again as the AI investment binge rolls on. The US corporate sector is also getting a reduction of uncertainty over future tax policy, and the US consumer is getting a potential boost with the passage of tax cuts and reforms within The One Big Beautiful Bill, which is what Noelle Dixon and I talked about on the podcast a few weeks ago before I went on vacation.

So this isn't just a case of Trump starting big, scaring markets, then retreating when he doesn't like the outcome. There's actual good news here. The problem now is that sentiment positioning in those pesky analyst forecasts are basically back to where they were at the start of the year and look as rosy as ever. Two weeks ago, the investor percentage portfolio allocation to global equities hit its highest level since November 2007. The weight in equities relative to fixed income is at its Highest point since September 2008. The consensus risk of the US equity Overweight. It's about 20 percent smaller than what it was at its peak value, but it's still the biggest country risk out there by a mile.

The combined overweights in IT and communication services stocks these are the max seven. For the most part. Those are only about 5 percent smaller than they were at their recent peak. To their credit, institutional investors didn't panic. They anticipated the volatility. They bought the dip. They were handsomely rewarded for it. And those gains are sustainable. But so long as earnings continue to perform as well as they have, and especially as long as the risk seeking flows we still do see in our institutional investor allocations continue. But I would really keep my eyes on those sentiment indicators, especially our behavioral risk scorecard. It turned fearful early, as you definitely want to do in a period of market volatility. And it got greedy early too, when markets started to recover.

I'm not certain why it should be any different the rest of this summer given expectations have readjusted very, very quickly.

Now about those tariffs. The second big question I have that markets will likely need to figure out is if and when we will ever start to see any outsize effects of the tariffs so far coming through in the inflation numbers.

And then how much will that effect be? And will it result in any de anchoring of long term inflation expectations?

Because I suppose that could also spell trouble for risky assets. The Federal Reserve has cited this as the main reason why they're delaying further policy easing, much to the consternation of the President and his administration. Of course they want to see much lower rates and given the run of inflation releases since Liberation Day, which have shown no immediate pass through from tariffs into headline and most core prices, you can kind of see where they're coming from. But here again, victory lap for us for the last three releases of US CPI, our bottom up forecasts that we derive using online price data from price stats have correctly forecast the eventual downside. Surprise. We've regularly talked about this on this podcast and in our research about how other factors pushing inflation down, things like shelter costs and energy prices have offset any tariff driven inflation that we might have seen or expected. And the inflation we've seen that can be blamed on tariffs? Well, we've talked a lot about that too. Prices of goods in sectors with high import content from China think things like household appliances, electronics, clothing and apparel.

In those categories we've actually seen much stronger than normal inflation and we've done so basically since Liberation Day. A recent podcast we did with PriceStats founder Alberto Cavallo talked about some of his new work which isolates the prices of goods that retailers are importing from China. And we definitely see the impact of tariffs or what we think are coming from tariffs coming through in that data. But it's not been enough to offset some of those other disinflationary factors. And it really highlights just how important service prices and prices of goods that originate domestically in the US are. These right now are significant down weights in the overall price basket and they're obviously not subject to tariffs.

And in some senses you could expect their effects to continue to offset any upside tariff pressure we see. But of course we are now starting to get a lot more clarity on what the end state for tariffs looks like for most US trading partners. Maybe now is the time that retailers will start to act more aggressively to pass those higher costs onto consumers and raise prices.

Alberto also noted a few months back that it's not uncommon to see retailers wait and see when it comes to tariffs. They run down their existing inventories and then they adjust prices once they know what the outlook is a little bit better. The Fed's certainly waiting for that effect to take hold and they've cited the July CPI data as when they might start to get a better picture of those effects.

What are we seeing?

The aggregate price level in the US now actually is a little bit higher than it normally would be at this time of year. Remember, US price movements especially are highly seasonal.

Once you adjust for that seasonality, you can see our overall price debts index is about 2025 basis points higher, 0.2-0.25 percent higher than it normally would be in late July. But remember, that's accumulated excess inflation which is pretty small to begin with. That has come over a span of months. It hasn't been immediate. It's still a long way from the one off massive price shock that might have been feared. Now that shock still may come. It could bleed in over time. But so far the evidence of stagflation or a long term de anchoring of inflation expectations is really limited.

And actually remember those import sensitive sectors I talked about a little bit ago as being stronger than normal when it came to their inflationary pressures?

That pressure's still there, but the outsize effects are actually starting to recede. In the series we track of online prices for goods imported from China, it actually looks like it leveled out in June and July. Prices of domestically generated goods have basically been flat for the last four or five months. The inflation picture really doesn't look that bad. But this is still a big question mark, especially where China is concerned. As I record this, a further delay to the full imposition of tariffs on China is being negotiated. It's an open question for a little while longer as to what Chinese Tariffs will look like in their end state, and that's super important given they're still a huge US trade partner.

So I'm going to talk about that with Michael Metcalfe, more about this inflation question, as well as a couple of other things, including our next question on next week's podcast.

Okay, each of the answers to our first two questions will probably have a lot of influence on the answer to the final question I have for markets, which is what to make of the US dollar.

From here the dollar's fallen a fair bit. It's about 10 percent lower on a trade weighted basis, about 8 percent lower in real terms once you adjust for local price differentials like stocks.

Long dollars was a massive consensus trade at the start of 2025. Investors were heavily positioned, presumably on a belief in continued US exceptionalism or that tariffs and fiscal policy would push US rates a lot higher and give further support to the already generous carry that you already get from owning dollars. We also have talked about how there was an expectation that US stocks would do well and maybe attract capital into the US on an unhedged currency basis. But of course not all of that actually happened and the significant policy uncertainty created by tariffs drove a broad questioning of US exceptionalism and to some degree a questioning of whether it was still appealing to own the US dollar and US assets.

In our flows we started to see dollar selling and again it was well before the trend change in the dollar like with US equities. We started to see dollar selling and the start of the unwind of this massive consensus risk as far back as early December. That was actually a little bit costly. The dollar only peaked out in mid-January, but the selling continued then and it ramped up in March, May and June as that bigger dollar correction unfolded.

So again, our flow data caught this unwind really nicely.

Have I mentioned you really should follow our stuff more closely? Positions have flipped, institutions are underweight, and the broad market indices of the dollar have been flat for about six weeks. On a personal note, I've been a dollar bear for most of this year and really until the last couple of weeks I've never really questioned that as we continued to see strong dollar selling. In fact, between the end of April and the start of July, we saw only one trading day of dollar buying from real money investors. So, the flow signal pushing down on the dollar and really driving that view couldn't have been more obvious. But there's now a big difference between the consensus risk that slightly unwound in equities that I talked about a few minutes ago and the consensus risk that massively unwound and in fact flipped around in the US dollar.

The current position risk could not be more different than what we see in US equities. Institutional investors are now heavily underweight the dollar and the selling has started to moderate. It isn't a record short position. They aren't buyers yet and they're certainly not anywhere close to strong buyers. In fact, there's actually a future source of dollar selling pressure that hasn't yet materialized in that the mountain of US Stocks that foreign investors own has not been currency hedged to nearly the degree that it could be.

As a result of that, I am still a long term dollar bear. I do expect another 8 to 10 percent depreciation in that real effective exchange rate over the next year or so. Maybe, but I'm starting to wonder if tactically short term we've seen the worst and if the summer brings some better days. To some extent we have started to see this in price, but the near term selling pressure that we capture in investor flows is only just recently starting to moderate. Over the last week they're net neutral and we've seen a couple days’ worth of modest buying.

So tactically we are starting to look at short term dollar longs, especially against other safe haven currencies. Given the risk taking of institutional investors outside of currencies still looks pretty robust. There's more on that in the Developed Market Strategy Weekly that came out yesterday. Now, how far any countertrend bounce for the dollar might get, whether it could actually break the downtrend and whether it could actually force me to rethink my bearish long term view. Those are the questions I'm going to ponder the rest of this summer. And if you haven't gotten the message by now, I think our measures of institutional flow and positioning for dollars will be a really helpful signpost for all of that. That's it. I've taken my summer vacation, but if you haven't enjoy yours podcast will be back next week. As I said with Michael Metcalfe. He runs our strategy team globally. We're going to touch on some of these questions as well as a few others. In the meantime, here's another final clip of one of my musical highlights of the summer so far.

Thanks for listening to Street Signals. Clients can find this podcast and all of our research at our web portal Insights. There you'll be able to find all of our latest thinking on markets where we leverage our deep experience in research on investor behavior, inflation, media sentiment and risk. All of which goes into building an award winning strategy product. And again, if you like what you've heard, please subscribe wherever you get your podcasts and leave us a review. We'll see you next time.