Monologue
There were two major macro developments this week, which created fascinating cross-currents for markets and materially shifted the outlook.
Last Sunday afternoon, President Trump announced that a Memorandum of Understanding (MoU) would be signed with Iran to extend the ceasefire, open the Strait of Hormuz, and define a path to negotiations on a long-term peace agreement. Iran has been given financial incentives for making progress toward a long-term deal. The spot WTI crude benchmark closed the week at $76.6 per barrel, its lowest level since March 3rd. Fixed income rallied too as the good news on the inflation front removed baseline expectations of a Fed hike.
The bond market party was short-lived. If President Trump thought that announcing a deal before Kevin Warsh's first meeting as Chair of the Federal Reserve on Wednesday would reinforce his case for lower rates, he misjudged his nominee. Warsh's overall message was hawkish, and he clearly has two goals in mind: (i) in the near term, get inflation to target to re-establish the Fed's credibility, and (ii) over the course of his term, introduce deep reforms to adapt and improve the functioning of the Fed as an institution, possibly setting up a period of moderate real interest rates justified by rising productivity. Our detailed commentary on the meeting can be found in the Macro Monitor below.
So, what are the economic consequences of Warsh and Peace?
First, we resist the temptation to overreact. The reopening of the Strait of Hormuz does not change the fact that the US is currently in a mild "Stagflation" regime, tending toward an "Overheating" regime if investment-led growth rises alongside prices. And, as we've argued many times, underlying US inflation is about far more than energy prices.
This entrenches our opinion that interest rates will rise by 25-50 basis points over the next three to twelve months, perhaps as early as September. This feathering of the brakes looks necessary to keep aggregate supply and demand in balance and contain excessive optimism in equities.
As for the medium-term horizon, neither of these two events changes the scenarios we identified as relevant in our Quarterly Update. However, they do meaningfully alter the probabilities toward a well-managed supply shock.
We now assign a 70% probability to the scenario in which the Fed tightens modestly to offset inflationary pressures, without collapsing economic growth. Given the Fed's proactive inflation outlook and positive direction of travel in the Gulf, an explosive, enduring stagflation is now a 10% tail risk. Finally, we see a 20% chance that a disinflationary softening in consumer spending, perhaps accompanied by a stock market correction, puts cuts back on the table.
Here are the updated summaries:
- Scenario 1: Supply Shock Sorted [Updated weight: 70% (prior weight: 40%)]: A stalemate in the Iran conflict persists through most of 2026, driving annual headline inflation to 5%. Growth slows but remains positive, driven by AI-related investment and fiscal largesse. The Fed shifts to a hawkish tone mid-year, and a rate hike follows around the turn of the year. This proactive stance means that the Fed can limit the response to two 25bp moves, which transmit through equity prices and credit conditions to cool the economy and contain second-round effects.
- Scenario 2: Stagflation Nation [Updated weight: 10% (prior weight: 30%)]: The Strait of Hormuz blockade is not fully lifted until 2028, with intermittent openings and closures amid a frozen conflict keeping oil prices volatile and global hydrocarbon-linked supply chains severely disrupted. The inflation shock dampens demand. The Fed opts to “look through” the shock initially, allowing price pressures to move beyond volatile headline categories and into slower-moving core prices. A Stagflation regime results, with anemic growth and asset prices driven by their inflation betas.
- Scenario 3: Rapid Resolution [Updated weight: 20% (prior weight: 30%)]: This scenario contemplates a deal to reopen the Strait of Hormuz in the very near term, enabling inflation to peak and begin falling in 2026. Within 12 months, the Fed eases interest rates and delivers another cut in the second year of the scenario to arrive at its judgment of the neutral rate. Meanwhile, growth remains around the long-run average, supported by the AI investment boom and fading economic uncertainty as a Democratic-controlled Congress mitigates executive economic policy risk (but lingering consumer weakness outside the top deciles prevents an overheating).
I should close with a word of caution. Some uncertainty has been resolved this week, but plenty remains, and new "known unknowns" have been introduced. For one thing, the US/Iran(/Israel) deal has not been fully finalized. Shipping bosses have pointed out that a draft released this week leaves the door open for Iran to toll transits of the Strait of Hormuz. Plus, Iran is now acutely aware of the leverage it has over the US in upcoming negotiations, should the Strait close again just ahead of the November midterm elections [update: Iran has reportedly closed the Strait in response to conflicts between Israel and Hezbollah, underscoring the fragility of the agreement].
On the monetary policy side, we've learned that Warsh is not a lapdog, and that he wants to re-establish the Fed's inflation-fighting bona fides. But details on his planned reform agenda are extremely light. The broad remit of his new task force suggests the potential for major reforms with lasting market implications. As we note in our Macro Monitor, investors will need to stay nimble and intellectually flexible regarding policy rates.
With that warning in place, enjoy this week's note.
Dylan Smith
Founder and Chief Economist
Marginal Movers
Rising 👆
- Private market liquidity: Canada pension’s new PE head shakes up continuation fund formula — Under the leadership of Jon Salon, the new group will fund preferred equity issuance and recapitalizations, invest in continuation vehicles and take minority stakes in companies, as part of a strategic response to the prolonged liquidity shortage in private markets."
- Tokens: Tokenization: What it is and how to think about it — "Tokenization could transform market structures and the way money and financial assets are issued, transferred, and settled. So far, adoption is still in its early stages."
Falling 👇
- Firm size: AI-Native Firms * — "Relative to non-AI startups in the same industry-cohort, AI-native firms are 25% smaller. Their share of engineers is 13% greater, and the shares of entry-level workers and managers are each roughly 15% lower. Their hierarchies are half a seniority level flatter—yet valuations are comparable, implying more value created per employee."
- Remote work: We Liked Remote Work. Then We Looked at the Data. — "Despite its advantages, remote work has significantly deepened Americans’ isolation and distress. Our estimates, published in Science this month with our collaborator Amanda Pallais, indicate that remote work explains a third of the deterioration in mental health over the last 15 years."
Macro Monitor
I've Got a Committee for That
We published our quick take on Warsh's first meeting on Wednesday evening. Nothing in the analytical response or market moves since has shifted our views immediately following the meeting, so we repeat it in full here:
What happened
The Federal Open Market Committee (FOMC) left the target range for the Federal Funds Rate unchanged at 3-1/2 to 3-3/4 percent.
The Fed's commitment to "deliver price stability" was explicitly reiterated in a shortened Statement that we read as modestly hawkish. The Chair's desire to return inflation to target and enhance the Fed's credibility on its inflation mandate was repeatedly emphasized throughout his press conference.
"Forward guidance" was dropped. The Fed will no longer attempt to "steer" markets regarding the direction, pace, or degree of future interest rate decisions.
The scheduled Summary of Economic Projections (SEP) was published, but its contents were downplayed in line with the move away from forward guidance. Breaking from recent practice, Warsh did not submit his own economic projections or "dots" indicating his modal forecast of the path of the Fed Funds Rate. In the press conference, he hinted more than once that by the end of the year, the SEP will likely be significantly altered or dropped entirely.
Nonetheless, the dots showed that half of the committee believes that the policy rate will need to rise by the end of 2026, affirming that the committee is mindful that this week's ceasefire alone does not mitigate underlying inflationary pressures. The median projection for the policy rate now sits at 3.8% at the end of 2026 (one hike, up from one cut in March) and 3.6% at the end of 2027 (up from 3.1% in March). To be clear, a ceasefire with Iran is not a sufficient development to bring inflation back to target in the minds of half the committee.
Chair Warsh announced the formation of five new task forces to recommend reforms to almost all elements of monetary policy. Further details, including the members of each task force (who will come from both inside and outside the Fed), their exact remit, and their reporting timelines, were deferred to the next FOMC meeting. Most attempts by journalists to entice some forward-looking commentary from Warsh were met with the refrain "I've got a committee for that."
The five task forces will review:
- The Fed's communications strategy.
- The Fed's balance sheet.
- The production and use of economic data that the Fed relies upon.
- Production and jobs in a time of technological transformation.
- The Fed's inflation frameworks.
Almost all elements of monetary policy are under review — the 2% inflation target is out of scope, at least until the Fed re-establishes its credibility in achieving its current mandate.
What it means
- Kevin Warsh is his own man, with his own vision for the appropriate scope and conduct of monetary policy, and credible independence from Presidential interference. He would not be drawn to comment on his level of contact with the President during the press conference, but his repeated emphasis of the goal to deliver price stability, some balanced (not dovish) comments on the inflationary implications of AI, and his clear focus on credibility-enhancing reforms, all worked to dispel the notion that he's looking for a reason to ease rates under pressure from the White House. Our impression was of a man who knows his term will outlast that of his nominating President, with an ambition to make his mark on economic history.
- We have entered a phase of institutional reform — the most significant since inflation targeting was developed in the early 1990s. Warsh has cast himself as modernizer-in-chief, enabled by "his task forces". His overarching aim is to materially reform the Federal Reserve. There is the potential for profound change in the relationship between policy communication and market pricing. Much-needed improvements may be achieved, but change brings risk too – both in conception and implementation.
- Markets will decouple from Fed communications, improving their ability to cleanly price risk. Warsh is clearly of the view that markets provide a more valuable social function when they can focus on pricing true risk and value, rather than policymakers' perceptions.
- Markets will react more to data and less to Fed officials' speeches. The overall effect on volatility is indeterminate at this stage, but the source of volatility will shift away from the people setting interest rates and toward the data (especially the data they emphasize as being reliable and important).
- Investors will need to be nimble and intellectually flexible. On some key market-moving debates, investors may be vulnerable to shifting goalposts as the task forces conduct their work. Changes to how the Fed defines certain aims, its preferred data sources, or how it conducts its operations, could have serious consequences for interest rates. Markets need to learn to adjust quickly and guard against reflexive instincts. For example, the Fed may not adjust its 2% target, but the committees on data or inflation frameworks may recommend using a new inflation series as the benchmark, which could, in turn, imply a different interest rate than the old benchmark.
Consumers still consuming
US retail sales picked up by 0.9% MoM in May, growing faster than consumer price inflation of 0.5% MoM. Weekly tracking from Redbook shows that momentum has picked up further in early June.
The signal north of the border is encouraging, too. Canadian retail sales rose at a rate of 0.5% MoM in April (3.7% YoY), and preliminary estimates for May point to an acceleration to 1.0% MoM.
See the appendix for arcMacro proprietary Factors and the Key Macroeconomic Indicators tracking chart.
Market Monitor
If you were in any doubt that macro is back in charge of markets, the violent moves in bond markets this week will set you right. There was some push-and-pull between the tentatively positive developments in the Gulf and Kevin Warsh's hawkish first Fed meeting.
Warsh won out. The 2-year Treasury posted its worst performance on a Fed meeting day since March 2008, jumping by 26 basis points as a gradual shift away from higher rate expectations over the prior week was violently reversed by the Fed's statement and dot plot. Longer-dated bonds were slightly less badly hit (the 10-year yield actually fell on the week), flattening the yield curve. This was a US-specific move; Canadian and European bond markets rallied on the back of the ceasefire agreement.
The pop in interest rates and the return of the "US exceptionalism" narrative helped the dollar climb by a hefty 1.1% this week. They also hurt zero-yielding gold, the price of which dropped by $35.1 per ounce. Gold is now down by exactly 5% year-to-date, making it easily the worst-performing major asset class.
Oil prices moved significantly lower, of course, with the WTI crude benchmark closing at $76.6 per barrel, prompting debate over whether the rally has now gone too far. Relative to recent prices, the move seems extreme, but relative to the first two months of the year, during which oil market discussions hinged on global excess capacity, a $10 premium capturing Hormuz re-closure risks and gradual supply recovery looks like the lower end of reasonable.
Stock markets had a mixed week, with cyclical or energy-exposed sectors taking a beating, while tech pulled the S&P 500 into the green (up 0.9% on the week). The star performer was EM equities, up 4.2% in a single week. Most of this week's move reflected a relief rally, as dwindling supplies of petrochemicals, fertilizers, and plastics are expected to be replenished soon. Still, the MSCI EM index has risen by 28.5% this year. There is a strong fundamental story in EMs too.
See the appendix for the market monitor table
Memo
Update on AI and Business Formation
Bottom line: There is more evidence that AI is contributing to the rise in business formation. However, these businesses are employing fewer workers. The overall labor market impact is indeterminate at this point.
What it means for investors: Think in general equilibrium. AI-enabled services that replace workers may be run by a large group of small, weak-moat businesses that employ labor from the labor pool they replace. This market would be highly competitive, enabling efficient price discovery.
Only a few months ago, we published a Memo on AI and small business creation. Things are moving fast, and this topic is gaining increasing mainstream attention, so it's time for an update.
Most commentary presents the chart below and leaves it there.
A rosy story to be sure, but the reality, as always, is a lot messier.
First of all, can we attribute this pickup in business formation to AI? The timing is suggestive, but proves nothing. When we wrote on this topic in February, we showed by separating new business registrations by AI-exposure that the new technology may not be the driving factor. We can update that view now: AI exposure does seem to be playing a role in higher business formation, though it's still not the only factor at play.
One thing we can say for sure is that the relationship between business formation and employment is looking a little different in the AI era. We know from official data that fewer and fewer business applications are being filed with a timeline for the employment of ordinary payroll workers. This trend appears to have accelerated in the AI era.
On top of that, we're not seeing a corresponding pickup in reported self-employment in the official labor market data, which one would expect if a lot of employees were leaving their firms to become AI-enabled contractors. The best data on employment by firm size (from ADP) provides no evidence either way that a boom in small-business formation is supporting labor demand.
Enter INSEAD's Hyunjin Kim and Harvard's Rembrand Koning, who collated data on Y Combinator cohorts and US venture-backed startups between 2020 and 2024, classified their "AI-native" status, and recorded their headcount and seniority. They found that AI-native firms are 25% smaller, but have a flatter hierarchy that equates to higher enterprise value creation per employee. There is one major caveat: the authors also show that this is largely being driven by product, not productivity. AI-native firms are stealing market share by embedding AI into their products, but AI is not making their own operations noticeably more productive.
A tentative conclusion
The available data points to AI tools lowering the barriers to business formation. However, this comes at the cost of employment by new firms, which can be smaller when founders are made highly productive by AI tools (think a software startup supported by Claude Code). Our own experience at arcMacro confirms this; AI tools have helped delay administrative and junior hires, and entirely negated some specialist roles, notably a coding-focused analyst.
The general equilibrium impact of AI-enabled business formation on labor demand is indeterminate at present (firms are smaller but more numerous, and they pay for goods and services from others), and potentially small on net. But this is a theme to keep monitoring.
Appendix
Proprietary Factor and Regime Model and Key Indicators
Disclosures
AI Declaration
All written content, analysis, and opinions are original and ascribed to the author. AI tools were used for proofreading and summarization purposes only. AI tools may also have been used in the development (codebase) of the analytical models reported in this document.
Disclaimer
This publication is for informational and educational purposes only and does not constitute financial or investment advice. Nothing in this report should be construed as a recommendation to buy, sell, or hold any security or financial instrument. Always consult a qualified financial advisor before making investment decisions.