The Fed’s not there yet — but markets are

Tensions in the Middle East are deescalating after both sides fired missiles at each other—and Trump – not happy - said this:

“We basically have two countries that have been fighting so long and so hard that they don’t know what the fuck they’re doing.”

It was pretty effective—at least from the market’s point of view. Oil prices continued to fall. US crude dropped another 3.5% yesterday and is now down around 15% from Monday’s peak hit at the opening bell. Bears are now testing the critical $65 level, which coincides with the major 38.2% Fibonacci retracement on the year-to-date decline. A break below this level could signal a return to the negative trend that had been building since the start of the year—a trend supported by the quickening restoration of OPEC output and weakening demand prospects due to Trump’s trade war.

Brent is already consolidating below its own major 38.2% retracement and is testing the 50-DMA to the downside, while natural gas has returned to $3.60 per MMBtu after testing the $4.20 level at the height of the latest Middle East tensions.

Easing stress in energy markets is excellent news for everyone who doesn’t want to see higher oil prices translating into accelerating inflation and tighter monetary policy. So the market mood is restored—and the Federal Reserve (Fed) doves are pressing the lemon particularly hard these days.

Fed Chair Jerome Powell said on the first day of testimony before Congress that they don’t need to rush into rate cuts. But when asked specifically about July, he didn’t say, “No, we won’t cut.” That alone was enough to get the doves dancing in the streets. The US 2-year yield dropped below 4.80% this morning as the probability of a July rate cut jumped from zero to 20%.

The combination of Middle East de-escalation and rising dovish Fed expectations sent the S&P 500 more than 1% higher—almost near a record high—while the Nasdaq printed a fresh closing high. The US dollar fell.

Now, all this raises a few questions. First, Powell—who said just a week ago that ‘everyone he knows thinks that inflation will rise significantly due to tariffs —has been squeezed like a lemon for just a few drops of dovishness. And those few drops were interpreted as a potential green light for a July cut.

But the thing is, cutting rates in July would, in reality, be rushing—because the trade uncertainties won’t be resolved by then. In the best-case scenario, the US will go ahead and impose tariffs on trading partners without further negotiations. The tariffs that become effective in July—or August—won’t be reflected in consumer prices until the fall at the earliest. In the worst-case scenario, the tariff deadline will be pushed down the road—under the excuse that geopolitical tensions delayed negotiations—and the uncertainties, along with the inflation risks, will be postponed as well.

So even if the Fed is seen cutting rates twice before year-end, it would be more reasonable to wait until at least September—or even October—to proceed. The US economy is showing some signs of stress. House prices are falling, and consumer reports are volatile—strong one day, weak the next—which is ultimately hurting confidence. But company earnings remain strong, stock prices are near all-time highs, valuations are inflating, and the jobs market remains resilient. The Fed should keep some room to act if things truly worsen—it can’t just cut now and risk overheating the economy.

As such, it feels like the dovish Fed expectations are being pushed to the extreme. Long S&P500 positions are overly crowded among retail traders, while CFTC data suggests no strong interest from big players near record highs. So I think this latest rally is a time bomb. A correction is probably needed, and several factors could justify it: overdone Fed optimism, unresolved trade uncertainty, and the exploding US debt. Every additional point on the S&P 500 just increases the size of a potential drawdown.

In Europe, the convergence trade isn’t holding up well against the backdrop of rising dovish Fed expectations and the possibility of a pause from the European Central Bank (ECB).

The Stoxx 600 rebounded more than 1% yesterday after a 4% correction since mid-June. But the S&P 500 is clearly back in favour. European defense stocks, which carried the indices higher in H1, have probably already priced in most of the benefits from increased government spending. There could be another leg up—if the US doesn’t confirm it would protect a NATO member in case of attack—that’s a major current concern.

But beyond defense, the rest of Europe’s equities are facing tariff uncertainty. My concern is that the last bricks being added are making the tower too tall to stand on its own—and we could see a sizeable correction on both sides of the Atlantic sometime this summer. At least, that would justify the rising dovish Fed expectations.