A Hawkish Fed on Pause: The Monetary Context Entering Q3

Since the start of 2026, the Federal Reserve has been navigating between economic resilience and stubborn inflation. The May core PCE came in at 2.6% year-over-year — slightly above expectations and above the 2% target for the third consecutive month. Kevin Warsh, who took the helm of the Fed earlier this year, has maintained a resolutely hawkish stance: no rate cuts are envisaged for 2026, and futures markets now assign a 70% probability to a rate hike in 2027.

Warsh’s conviction is that artificial intelligence represents a « structurally disinflationary force, » but its effects on prices will only materialise over the medium term. In the short run, it is the labour market that determines policy. In this context, the June jobs report — released this Thursday July 2 by the Bureau of Labor Statistics at 8:30 AM ET — is the last major macroeconomic data point before the FOMC meeting at the end of July. Its content will literally set the monetary debate for the entire third quarter.

Markets are in a rare state of suspension. The 10-year Treasury yield hovers around 4.40% — slightly below May’s peak — as oil prices retreated following the Middle East de-escalation. The S&P 500 is consolidating after a solid first half (+7.2% YTD). Credit spreads remain compressed at 380 bps on US high yield, despite repeated warnings about valuation fragility.

May 2026: The Upside Surprise That Complicated Everything

The May report put markets under pressure. The BLS announced +172,000 net jobs — twice the initial consensus of 85,000. Leisure and hospitality (+70,000, partly driven by the World Cup), local government (+55,000) and healthcare (+35,000) drove the upside surprise. Only the financial sector fell (-22,000), a victim of the wave of AI-driven restructuring.

The unemployment rate held steady at 4.3%, and hourly wages grew +3.5% year-over-year — a pace that, according to the Fed’s own models, is consistent with inflation in the 2.5%-3.0% range, far from the desired convergence toward 2%. Upward revisions to March (+214,000, up 29,000) and April (+179,000, up 64,000) reinforced the picture of a still-vigorous labour market.

For June, the economist consensus is notably more modest: between +87,000 (Bank of America, which anticipates a correction after May’s wave) and +160,000 (high estimate), with a median around +113,000 jobs. The unemployment rate is expected to remain at 4.3%, and wages at +3.5%. Some economists — including Vanguard’s senior economist — even envisage a scenario of +50,000, citing post-World Cup seasonal normalisation.

Three Scenarios for June: From Cooling to Overheating

Our Q3 positioning is built on a probabilistic weighting of three possible configurations for the June NFP. Each implies a distinct market reaction, particularly on rates, the dollar and equity segments.

Favourable Scenario — NFP < 130,000 (Probability 25%)

A below-expectations print would reopen the debate on a late-2026 rate cut. The 10-year Treasury yield could fall back below 4.20%, providing welcome relief to bond issuers. IG and HY bonds would benefit from a surge of buyers. Growth equities — highly sensitive to real rates — would rebound 2%-3%. Gold would edge up toward $3,400/oz. The dollar would lose 0.5%-1.0% against the euro. For balanced portfolios, this is the most comfortable scenario: bonds and equities rise together.

Base Scenario — NFP between 130,000 and 180,000 (Probability 45%)

Markets digest without disruption, the Fed is confirmed in its pause. The 10-year yield holds steady around 4.35%-4.45%, markets are calm, range-trading through to the FOMC meeting at end-July. This is the least spectacular but most probable scenario. It favours short-term carry on IG 2-5 year bonds and dividend-paying value equities in Europe, less sensitive to rate fluctuations. Eurozone money market funds continue to offer attractive yields above 3%.

Adverse Scenario — NFP > 180,000 (Probability 30%)

Another upside surprise would be poorly received by markets that have already absorbed multiple upward revisions. The 10-year yield would break above 4.50%, and the equity market would correct 2%-3% — tech and growth stocks leading the selloff. The dollar would appreciate, gold would hold around $3,200/oz thanks to its geopolitical hedge role. This scenario would strengthen the thesis for a 2027 rate hike and push the Fed to adopt an even more restrictive tone at its end-July meeting.

Our Q3 Positioning: Carry, Quality, Hedging

Faced with this uncertainty, our positioning remains defensive-neutral, centred on carry and issuer quality. These four orientations hold in two out of three scenarios, making them robust regardless of the June NFP outcome.

On equities, we favour defensive sectors — healthcare, utilities, consumer staples — and high-dividend equities in Europe, less sensitive to real rate swings than US tech. The sector rotation toward European value, initiated in Q2, remains relevant: valuations are reasonable and the ECB, despite its recent hikes, is closer to its pause than the Fed.

Finally, money market instruments deserve to be held at 7%-8% of the portfolio. In an environment where the yield curve is flat to inverted on short maturities, remunerated cash provides a valuable agility option: in the event of a correction, you have an immediately deployable reserve.