Getting Accommodative
The economy is strengthening, while financial conditions are easing. It is a potent combination of growth and declining prices resulting from increased investment. At least that is what the Q2 GDP backward-looking data showed, which came in a touch hotter than expected.
Business investment is growing at over 5 percent annually for a second consecutive quarter, which is pushing down the core PCE implied by GDP (Figure 1).
The phenomenon—investment drives prices down—happened in the late 1990s, when internet/tech spending led to an investment surge, suppressing core PCE below the Fed’s target. If sustained, the Fed may become more accommodative in the quarter(s) ahead, which would represent a material change from its restrictive stance over the past three years.
Figure 1: GDP fixed investment and GDP price index/deflator (Y/Y%)
Source: BEA
As such, the market is pricing the Fed's accommodative stance as a change in real interest rates by as much as 2.5 percent in the following year.
Fed Funds futures expiring in August 2026, which account for inflation expectations one year from now, are trading at a rate of -0.30 percent. The Fed Funds rate, however, accounted for the fact that the GDP price index/deflator has risen by more than one and a half percentage points since April (see orange line in Figure 2).
Thus, if the Fed becomes accommodative in real terms, the number of rate cuts is expected to exceed 200 basis points over the next 6 to 9 months.
Figure 2: The Fed in real terms: expectations and Funds rate (%)
Source: Federal Reserve, BEA, CME
Yet, there is a lagged effect from tariffs, as the Richmond Fed published in a new paper. They conclude that firms that delayed passing through tariffs were delaying orders, deferring charges, sharing costs with suppliers, having longer shipping times, and offering legacy product exemptions from tariffs.
Other reasons include the initial absorption of costs or temporarily reducing margins to retain customers. Companies experiment with small, incremental price hikes to gauge consumer response through "stair-stepping” strategies, adjusting prices slowly. Price increases may be hidden in non-tariffed goods or subtle label changes, and to avoid noticeable sticker shock, by updating shelf labels or targeting less visible items.
Thus, there is a window of several months during which the “labor weakness” is the reason for the Fed to lower rates, and inflation is less of a concern due to the widespread delay of tariff pass-through, while the economy expands through investment.
The forward market in Treasuries prices a 300-basis-point yield curve slope (Figure 3). As the Fed still considers itself “moderately restrictive,” financial markets are discounting a significantly more accommodative stance in the period ahead.
Figure 3: Expectations are pricing a 300 basis points positive yield curve (%)
Source: CME
The prospect of this Fed policy shift is an accelerated upside in Tech stocks. Alpine Macro presented this chart of how the Nasdaq was trading in the late 1990s; markets are back into the psyche of a bubble that is initially seen as rational (see Figure 4).
Importantly, the GDP data is showing fixed investment rising ahead of any of the commitments made to the White House to invest in the US in exchange for low tariffs. The “AI Index” as published by Morgan Stanley/UBS composite of companies that generate revenues from AI, shows a widening divergence with software and expanded tech indices (see Figure 5).
The premium attached to AI is, from a macro perspective, a sign of markets readying for an investment and productivity boom into 2026-2027, which could drive short rates significantly lower, but as forward rates already imply, long-term rates move higher until the tariff revenues are proactively used to reduce long bond issuance.
Figure 4: It is the 1990s, again: Nasdaq
Source: Alpine Macro
Figure 5: AI is leading this market
Source: Morgan Stanley, UBS, NYSE