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G’day Blokes and Sheilas,

Welcome to the third edition of Macro Musk, where we take a wider view of global market forces and see what’s driving capital flows this week. The goal isn't to predict the future, but to understand the environment we're trading in so we can align ourselves with the highest probability opportunities. The weekend Musk Report looks at the week ahead; Macro Musk considers any longer-term macro nuances that might be relevant.

Let’s dive in…

At first glance, last week's market action looked like a simple "good news for stocks" story, and certainly it is proving that way… for the immediate term horizon considered in The Musk Report. But looking further ahead, some key developments are brewing. The US economy created far fewer jobs than expected, unemployment ticked higher, and investors immediately concluded the Federal Reserve would be under more pressure to cut interest rates. Lower rates generally make borrowing cheaper, support economic growth and encourage investors to move back into risk assets. That's why we initially saw Treasury yields fall, the US Dollar weaken and precious metals rally sharply.

The problem is that macroeconomics rarely offers clean, one-dimensional stories. While the labour market is clearly showing signs of cooling, several other forces are pulling in the opposite direction. Oil prices have resumed climbing slightly, as geopolitical tensions continue to threaten global energy supplies, inflation across the services sector remains stubbornly high, and even the Bank of Japan, after decades of ultra-loose policy, is becoming increasingly willing to raise interest rates. And that has implications far greater than many are willing to admit. Those developments all work to keep global financial conditions tighter than markets would like.

Perhaps the most interesting observation, however, is what hasn't happened. Despite rising yields, elevated oil prices and ongoing geopolitical uncertainty, credit markets remain remarkably calm. Investors are still willing to lend to companies at relatively tight spreads, suggesting there is plenty of liquidity circulating within financial markets. In other words, money is still finding its way into risk assets rather than hiding on the sidelines. That creates a much more nuanced backdrop than a simple "bullish" or "bearish" narrative.

For now, that leaves us in what I would describe as a transitional regime. The fundamental macro environment remains restrictive, but markets continue to display surprising resilience. Until one side of that tug-of-war decisively wins, we should expect increased rotation beneath the surface rather than a broad, one-way trend across all asset classes.

In a nutshell: The macro system is still restrictive from the outside, but markets are generating enough endogenous liquidity internally to prevent a straightforward risk-off regime.

Every market regime is driven by a handful of dominant macro forces. Rather than reacting to individual headlines, I focus on the underlying drivers that are influencing liquidity, inflation, economic growth and investor behaviour. These are the forces currently shaping global markets.

The US labour market has produced a genuinely weak jobs report. Payrolls unexpectedly fell by 23,000 in July, while employment surveys suggest businesses are becoming increasingly reluctant to hire new staff despite economic activity remaining reasonably healthy. In other words, companies are still busy, but they're no longer confident enough to keep expanding their workforce.

This fundamentally changes the Federal Reserve's balancing act. Until now, strong employment allowed policymakers to keep their focus firmly on inflation. A weakening labour market, however, raises the risk that further interest rate hikes could do more harm than good. Importantly, this doesn't mean rate cuts are imminent. The economy is slowing, not collapsing, and inflation remains stubborn enough to keep the Fed cautious.

Markets initially interpreted the jobs report as reducing the likelihood of another Fed hike. However, that optimism faded quickly as oil prices rebounded and inflation concerns resurfaced. The key takeaway is that the jobs report weakened the case for another hike, it didn't eliminate it. Investors are now looking to this week's inflation data to determine which narrative wins.

Over the past week, oil prices have reminded markets just how quickly the inflation outlook can change. Early optimism that tensions around Iran and the Strait of Hormuz might ease caused crude prices to fall sharply. But as hopes of a diplomatic breakthrough faded, oil quickly reversed course and has started grinding higher.

This leaves the Federal Reserve facing a difficult balancing act. On one hand, weaker employment suggests the economy is slowing. On the other, rising oil prices risk pushing inflation back up. Those two forces are pulling monetary policy in opposite directions much like the 70’s stagflation period.

Markets have largely priced out the worst-case scenario of a major Middle East supply disruption, but they are far from convinced the risk has disappeared. In other words, investors are no longer expecting an immediate energy shock, but neither are they assuming the problem has been resolved. That leaves oil highly sensitive to geopolitical headlines.

For me, Brent crude around US$90 per barrel becomes an important line in the sand. A sustained move above that level would make it much harder for the Fed to ignore inflation risks, even if the labour market continues to soften. A move back towards US$80 would shift the market's attention back to slowing growth and strengthen the case for the Fed to remain on hold. Until then, oil remains the market's biggest swing factor.

For decades, Japan has been one of the world's cheapest places to borrow money. Investors could borrow Japanese yen at extremely low interest rates and invest that money into higher-yielding assets around the world, a strategy known as the yen carry trade.

Over the past week, Japan officially confirmed it had intervened in currency markets to support the yen, with cooperation from the US Treasury. At the same time, the Bank of Japan signalled it may be prepared to raise interest rates faster than markets had expected.

Neither development is accidental. Together, they suggest Japanese policymakers are becoming increasingly uncomfortable with an excessively weak currency.

The objective isn't to create a permanently stronger yen. Nor is it to deliberately crash global markets by forcing investors out of the carry trade.

The objective is much simpler - Japan wants to stop the yen falling in a disorderly fashion. A rapidly weakening currency makes imported goods more expensive, pushes inflation higher, hurts households and eventually undermines confidence in the Japanese economy. By stepping into the market and buying yen, Japan is effectively saying: “We won’t allow one-way speculation against our currency.”

The US Treasury's involvement shouldn't be interpreted as America wanting a stronger yen either. Rather, both countries share an interest in preventing disorderly financial markets. A sudden collapse in the yen could trigger panic, forced selling and instability across global bond, currency and equity markets. The intervention is designed to slow the car down, not slam on the brakes. The conclusion appears to be that the Yen Carry Trade will unwind, what remains to be seen is whether it manifests as a violent reaction or an orderly process.

The yen carry trade has been one of the great liquidity tides of the modern era. For almost forty years, investors have been borrowing cheap Japanese money and deploying it into higher-return assets across the globe. That constant flow of capital has quietly supported everything from US equities and emerging markets to corporate bonds and property.

If Japanese interest rates continue rising and authorities remain committed to supporting the yen, that trade gradually becomes less attractive. Investors don't all rush for the exits overnight, but some begin reducing exposure and bringing capital home.

Think of it like the tide. When the tide suddenly rushes out miles offshore, run like hell because there’s a tsunami coming! Japan and the US are trying to manufacture a receding of the tide such that it doesn’t result in a tsunami coming back at them.

For forty years, cheap Japanese money has washed across global markets like an incoming tide of prosperity. If that tide is now beginning to recede, even if gradually, investors should expect the water level beneath risk assets to gradually fall with it. Hopefully the policy is effective and the beach doesn't get destroyed overnight, but you will start seeing more and more boats left sitting on dry sand… oh, and I hope you were swimming with your bathers on, because nobody wants to see that!

Following the weak US jobs report, bond yields initially fell as investors scaled back expectations of another Fed rate hike. But the move was short-lived. Within days, longer-dated Treasury yields had climbed back towards their recent highs, suggesting investors remain concerned about inflation, government borrowing and long-term economic risks.

This tells us the bond market is worried about more than just the Fed's next decision. Even if policymakers leave interest rates unchanged, higher long-term borrowing costs still tighten financial conditions by making mortgages, business loans and corporate funding more expensive. In other words, the economy doesn't need another rate hike for financial conditions to become more restrictive.

Markets are drawing a distinction between the short term and the long term. Weaker employment has reduced expectations of another immediate Fed hike, but investors continue demanding higher yields to compensate for inflation uncertainty, heavy government borrowing and the growing supply of US Treasury debt.

A genuinely dovish market would normally see long-term bond yields falling alongside weaker employment data. The fact they quickly recovered tells me financial conditions remain tighter than many investors appreciate. Until the long end of the Treasury market begins trending lower, I'd be cautious about declaring that liquidity has genuinely improved.

The market expects the Reserve Bank to leave interest rates unchanged. That, by itself, isn't the story. The real question is whether the RBA believes inflation is still stubborn enough to justify another rate hike in the future. While headline inflation has eased, underlying inflation remains elevated, housing costs continue to rise and higher oil prices risk adding further inflationary pressure.

Interest rate decisions are often less important than the guidance that comes with them. If the RBA signals inflation remains a concern, markets are likely to push Australian bond yields and the Australian dollar higher. A more dovish tone, on the other hand, would suggest the tightening cycle is nearing its end and could provide support for interest-rate-sensitive sectors.

Markets have largely priced in a hold. What they haven't fully priced in is whether the RBA becomes more hawkish or more dovish from here. That's where the surprise is most likely to come from.

Don't focus on whether rates stay at 4.35%; almost everyone expects that outcome. Instead, pay close attention to the RBA's forecasts and Governor Bullock's commentary. The decision will tell us what the RBA did today. The guidance will tell us what they are thinking about tomorrow.

US 30 Year

CME FedWatch Rate Hike Probabilities

The probability score of a rate hike tells us which issue is dominating the market narrative. Above 60% = Inflation / Below 35% = Jobs weakness.

Brent Crude

USDJPY

DXY

No single chart will determine the market's next move. What matters is how these signals interact. A combination of soft inflation, falling bond yields, lower oil prices and healthy credit markets would point towards easing financial conditions and a more supportive backdrop for risk assets. Conversely, a hot CPI print alongside rising oil, higher long-term yields and renewed weakness in the yen would reinforce the higher-for-longer narrative, tighten financial conditions and increase the risk of further intervention or a disorderly unwind of the yen carry trade.

That's why I focus on the mosaic rather than any individual chart. The market regime is rarely defined by one indicator. It emerges from the interaction between them all.

One of the most interesting conclusions from this week's analysis isn't what changed over the past seven days, it's how those changes compare with the analysis in The Musk Report published just a few days earlier.

The technical evidence continues to support a constructive short-term outlook. Market breadth has improved, credit remains healthy, the US dollar has softened and several cyclical assets have begun behaving more positively. On its own, that would normally justify a bullish stance.

The macro picture, however, urges a little more caution.

Rather than confirming the beginning of the next major secular bull market, the evidence suggests we may instead be experiencing a relief phase within a broader late-cycle environment. Financial conditions remain restrictive from a longer term view, inflation risks haven't disappeared, bond markets continue sending warning signals and one of the world's largest sources of liquidity may be starting to change direction.

So what does that mean?

It doesn't mean we abandon bullish positions or the weekend analysis was wrong. It means we become more tactical. They are two totally different time horizons.

It means you can enjoy the strength while it's there, but don't become complacent. Treat this as a market that still needs to earn the right to become structurally bullish. If the technical picture continues improving and the macro backdrop follows, then our long term view will flip into line with our 1-week view. But until then, You have to respect the warning signs.

As always, let the evidence guide the conclusion, not the other way around.

Cheers
Musk

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