The rebound looks somewhat exhausted this week, after markets had another impressive month in May. So the ‘TACO’ trade adds to risks of a White House tantrum, as does geopolitics. Overly rich valuations are not the issue though, and – counterintuitively – even less so with Treasury yields flirting with 5%. 

Markets are telling us that the pain trade is up, and we agree. But there is only so much pain that can be endured. Looking at market internals, even the biggest bulls may now be calling for a ‘healthy breather’, or even a setback. Looking for excuses to reverse some of the gains, the ‘TACO’ trade comes to mind. As a result, expect tantrums at the White House with hard-to-be-modelled impact on the upcoming round in the chicken game.

That said, we do not share the valuation concerns that have been raised recently. Some observers feel that a US Treasury bond yield flirting with the 5% level is a show-stopper for stock markets. If history is any guide, the opposite is true. The highest multiples for US stock markets were in fact paid when the US government had to foot the current, or even slightly higher, long-term bill for issuing debt. If anything, the ‘big, beautiful tax bill’ – outlined in detail below - does not spur insolvency fears. US Treasury Secretary Scott Bessent was only stating the obvious when he said that the US will ‘never default’ on its debt. That is an easy one, as they print the money in which they issue their debt. Yet the bill reminded global investors of financial repression, making them want to look for alternatives.

US policy moves: Understanding the ‘One Big, Beautiful Bill Act’

The tax bill passed by the US House of Representatives and dubbed by President Trump as the ‘One Big Beautiful Bill Act’ (OBBBA) primarily aims to make permanent certain large tax provisions that would otherwise expire by the end of the year. Some tax exemptions on tips and overtime pay were also added, in line with Trump’s campaign promises. Meanwhile, spending cuts on entitlements will offset 25%–30% of the costs over a ten-year period. While the tax bill prevents an increase in individual income taxes in 2026, it falls short of providing additional fiscal stimulus.

At the same time, the persistently high US fiscal deficit, which was 6.9% of GDP by the end of 2024, remains unaddressed. Furthermore, higher interest rates could worsen the US fiscal outlook. Thus, the OBBBA tax bill increases the incentive to use various forms of financial repression to balance the worsening fiscal outlook and prevent it from becoming unsustainable. Threatened and partly imposed unilateral tariffs are intended to force foreigners to pay for trading with the US. Section 899 of the tax bill authorises the Treasury Secretary to designate certain countries as ‘discriminatory’ based on ‘unfair foreign taxes’, which include digital service taxes and global minimum tax top-ups proposed by the OECD. The US would then impose a withholding tax ranging from 5% to 30% on interest income, property gains, and business profits, creating another form of financial repression. 

Finally, the fiscal recklessness of the most recent legislation puts stress on the Treasury market, increasing the likelihood that the Fed will need to step in at some point to ensure the market functions smoothly and cap yields, thus avoiding an unsustainable US fiscal policy stance. Although yield caps will protect Treasury bondholders from losses, we expect that foreign holders of Treasuries will suffer financial repression due to a depreciating US dollar resulting from the Fed’s interventions.

Equity markets: Rising yields pose a threat

The proposed extension of tax cuts – without matching spending cuts – would widen the fiscal deficit, potentially pushing long-term bond yields higher as investors demand more compensation for taking on fiscal risk.

While equity markets can typically accommodate gradually rising yields when supported by improving growth prospects, history suggests a turning point near the 5.0% mark for 10-year yields. Beyond that level, the positive correlation between equity and bond prices tends to reverse, as higher borrowing costs weigh on valuations and corporate profitability. The pace of rate moves also matters: equity markets tend to absorb moderate rate increases, but sharp upward shifts – particularly moves of more than 30bps in a month – have historically pressured equity markets.

In our baseline scenario, our economists forecast a modest increase in 10-year yields to 4.5% over the next 12 months, a trajectory that should remain manageable for equity markets if inflation expectations stay anchored. Furthermore, yield levels are likely to be naturally capped – either through renewed demand from private investors or, if necessary, intervention from the Federal Reserve. In short, while bond markets may need to reprice some fiscal risk, the base-case outlook suggests that yields will rise in a controlled manner, limiting downside pressure on equities.

ECB: Monetary policy is firmly in neutral territory

The European Central Bank (ECB) has cut rates by 25bps to bring the deposit rate down to 2%. We expect the ECB to stick to its strategy of deciding meeting-by-meeting with a heavy emphasis on incoming data, while refraining from giving any guidance on the future path of monetary policy. After the eight rate cuts delivered so far, the ECB deposit rate is now firmly in the range most estimates put in line with a neutral monetary policy stance. 

Further rate cuts from here are only justified if there are enough reasons for an outright stimulative monetary policy. The ECB will most likely proceed with caution after the rate cut in June and might even pause at its next meeting in July in order to grow more confident about the disinflationary impact of the trade shock. Growth risks from the trade shock are a good reason to cut rates further. Although USD bond markets may be dominant, the increased appetite for non-USD assets has spurred demand for alternatives such as EUR-denominated bonds for diversification purposes, and rightly so.

In fact, EUR bonds have some interesting features, and we see value at current yield levels. The outlook for monetary policy is much more clear-cut than in the US. This will inevitably increase reinvestment risks, supporting the demand for current yield levels for corporate debt with medium-term maturities (5–7 years). Moreover, under the radar, eurozone sovereign bonds are performing well, and some exposure to the segment is still warranted.

What should investors do next?

In terms of bonds, the ECB will sweeten the deal in the months ahead for those wishing to gain exposure to non-US assets, by lowering rates after major league grumbling. Of course, European bourses may be as overbought as their US counterparts and just as prone to a reversal of the TACO trade. Yet the prospects of more economic upside and less financial repression than in the US should do the trick. For now, focus on stocks that are ‘boring’ - in the best sense of the term.