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Video: CIO's Teck Leng Tan on using short-term USD rebounds to diversify dollar risk (01:55)

A risk-on mood returned to markets after the long Memorial Day weekend in the US, as investors reacted to signs of gathering momentum toward a US trade deal with the European Union.

On Sunday, US President Trump announced he would postpone the imposition of a 50% tariff on European Union imports from 1 June to 9 July, giving more time to reach a deal. In response, the EU on Monday agreed to accelerate trade talks. The president stated that talks were progressing in a “positive” direction.

The S&P 500 climbed 2% to 5,922, partially reversing last week’s 2.6% decline. S&P 500 futures at the time of writing stood down just 0.2%, suggest that the index could hold on to most of those gains, Beyond trade, sentiment was boosted by a revival in US consumer confidence. The Conference Board survey pointed to the biggest monthly gain in four years. The improvement was across age and income groups, as well as political affiliation, easing fears that trade tensions would have a longer lasting impact on consumer spending.

Finally, calm appeared to be returning to fixed income markets following last week’s global sell-off on worries over rising government debt. The yield on the 30-year US Treasury, which reached an intra-day high of 5.15% last week, a level last seen in October 2023, fell back below 5%. Sentiment in fixed income markets was also helped by a Reuters report that Japan’s Ministry of Finance plans to trim ultra-long issuance in response to recent turbulence.

What do we think?
Given the US president’s willingness to use forceful rhetoric in trade negotiations, further episodes of volatility most likely lie ahead as talks continue between the US and its top trading partners, most notably China and the EU. We do not expect a smooth path to agreement, and with the S&P 500 now just 4% from its record high in February, we believe further gains this year are likely to be relatively limited.

But the latest developments remain in line with our base case that pragmatism will ultimately prevail over confrontation. So far, the Trump administration has appeared to temper its more strident tariff policies in response to signs of distress in markets. We expect the effective US tariff rate to end the year around 15%. Assuming trade tensions continue to ease, we see room for the equity market rally to resume into 2026, with the S&P reaching around 6,400 by June next year, up from 5,922 at present. The rebound in consumer confidence is also in line with our view that the resilience of the US economy will continue to underpin markets, even if growth moderates.

We also remain positive on quality fixed income, despite last week’s sell-off. Concerns over rising government debt are well-founded. The “One, Big, Beautiful Bill,” which won approval from the House of Representatives last week, is likely to add trillions to government debt over the coming decade. Meanwhile, Japan’s prime minister recently described his nation’s fiscal position as “undoubtedly extremely poor,” and in Europe, higher defense spending and slow economic growth will add to fiscal strains.

However, reports of Japan’s plans to restrict ultra-long bond issuance chimes with our view that policymakers will respond to excessive swings in fixed income markets if needed. The Trump administration has also already shown a willingness to shift policy in response to rapidly rising yields, including pausing the “reciprocal” tariffs that unsettled markets in April. The Fed has also indicated its readiness to act if fixed income markets become dysfunctional. Our base case is that the yield on the 10-year US Treasury will fall back to 4% by the end of 2025, helped by a resumption of Fed easing later in the year.

How to invest?
The public negotiating style being adopted by the Trump administration looks likely to continue, leading to sporadic market swings. The challenge for investors will be to stick to their long-term plans and exploit bouts of volatility where appropriate.

Our view remains that the rally in equity markets can resume into 2026 and that the recent rise in yields offers an opportunity to lock in durable income. Against this backdrop we advise investors to:

Phase into equities: We recently downgraded US equities to Neutral. Trade and fiscal uncertainty are likely to continue driving near-term volatility. But longer term, we see further potential gains in stocks amid structural earnings growth, Fed rate cuts, and greater policy stability. Investors should use the coming months to progressively address strategic portfolio gaps and position themselves for further market rallies in 2026 and beyond.

Seek durable income: High grade and investment grade bonds offer appealing risk-reward, in our view. We believe yields on quality bonds in most major markets are attractive, and we anticipate the continuing global rate-cutting cycle will contribute to investor inflows. We also continue to see government bonds as a credible alternative to cash for investors looking to lock in currently elevated yields. Investment grade bonds are also appealing from a portfolio risk management perspective.

Sell dollar rallies: We don’t expect the latest revival in the DXY dollar index to persist over the long term as diversification continues and as focus increases on rising fiscal deficits. We recently downgraded our view on the US dollar to Unattractive. We like reducing excess US dollar cash by diversifying into other currencies such as the yen, euro, British pound, and Australian dollar. International investors should also review their strategic currency allocations and consider hedging US dollar exposure in US assets back into their home currencies.

Navigate political risks: We expect gold to remain a valuable long-term portfolio diversifier, supported by persistent geopolitical risks, ongoing central bank demand, and our view that real interest rates will decline as the US dollar weakens. We maintain our USD 3,500/oz target for the year. While gold may consolidate after its recent gains, price setbacks can be used to build exposure. Capital preservation strategies can also help retain gains and diversify portfolios. For investors looking to manage political risks, we recommend a mid-single-digit allocation to gold, alongside alternatives like hedge funds and capital preservation strategies on equities.