The US dollar is soaring, AI is booming, and the US Treasury yield curve is steepening... HSBC reviews the six major "pain trades" for the second half of the year!

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HSBC listed six "pain trades" in its latest multi-asset strategy report, warning that market consensus is at risk of being broken. Among these, an "explosive" surge in the US dollar, the continuation of the AI rally, and a steepening of the US Treasury yield curve are the three scenarios most likely to catch investors off guard.

According to ZF Trading Desk, HSBC global head of FX research Paul Mackel and other analysts stated in a June 29th report that while a stronger dollar will cause pain, the real "pain trade" in the FX market will be characterized by an explosive rally in the dollar. The bank has updated its forecast for the dollar to strengthen gradually through the first half of 2027, and warned that if the Fed signals a more aggressive tightening than the market expects, or if geopolitical tensions escalate again, the dollar could see a sharp move similar to that of 2022.

Meanwhile, HSBC maintains a bullish stance on risk assets, believing the extension of the AI rally to be another anti-consensus scenario. In the US Treasury market, the bank cautions that while the market broadly bets on further curve flattening, economic weakness forcing the Fed to pivot towards easing could steepen the curve and trigger rapid losses for those positions.

"Explosive" Dollar Rally: Two Catalysts

HSBC points out that the June Fed meeting was a key catalyst for the dollar's renewed strength. Policymakers focused on inflation without offering clear forward guidance, which shifted market attention to yield differentials and propelled the dollar higher against major currencies for two straight weeks. Bloomberg's dollar index climbed to a seven-month high in June, and hedge funds’ bullish bets on the dollar reached a 16-month peak.

HSBC believes there are two pathways for an explosive dollar rally. First, if the Fed signals intentions to tighten more aggressively than priced in over the coming months, front-end US yields will spike, rapidly tightening financial conditions and pushing the dollar sharply higher. Second, a resurgence of geopolitical tensions could once again dominate FX markets and drive Brent crude sharply higher, at which point the dollar will benefit from renewed safe haven demand.

The bank also notes that on a real rates basis, the euro has further downside against the dollar, and convergence to the level implied by real rate differentials would mean EUR/USD falling below 1.10. Historically, the cumulative dollar index rally is still significantly less than during the same period amid the 2022 Russia-Ukraine conflict, indicating further upside remains.

AI Rally Continues: Dual Support from Valuations and Earnings

HSBC views the extension of the AI trade as another anti-consensus "pain trade". Despite renewed skepticism towards the AI narrative, the bank says major AI-related stocks are not displaying signs of a valuation bubble. For example, Nvidia’s 12-month forward PE is under 20, a ten-year low, whereas Monster Beverage’s comparable metric is about 40, a ten-year high, highlighting a stark contrast.

On the earnings side, core AI names such as Meta, Amazon, Microsoft, Nvidia, Broadcom, and Micron grew actual profits in the past 12 months faster than their share prices, leading to falling rolling PEs. HSBC strategist Duncan Toms and others note that for many US companies at the frontier of the AI narrative, market expectations for full-year 2026 profit growth remain below the actual YoY pace seen in the 12 months up to Q2 2025, and upward earnings revisions are increasing. This means, if AI earnings momentum continues to surprise, the market will face the painful task of chasing the rally.

US Treasury Curve Steepening: Risk of Reversal for Flattening Trades

In US Treasuries, HSBC strategist Dhiraj Narula and others point out that the market started the year expecting a steepening curve, with the Fed having cut rates three times by 25bps, dot plots and forward pricing signaling more cuts ahead. However, oil shocks from Middle East conflict pushed inflation higher, the job market stayed resilient, and the Fed turned hawkish, sending front-end yields sharply higher. The 2-year vs 10-year spread (2s10s) and the 5-year vs 30-year spread (5s30s) both compressed by about 45bps, resulting in bear flattening.

Currently, market consensus has shifted from steepening to flattening, and many investors have established curve flattening trades. HSBC warns, if economic data deteriorates markedly and forces the Fed to resume rate cuts, the curve will steepen again, rapidly inflicting losses on current flattening trades. Although curve flattening trades may not be as crowded as steepening trades were at the start of the year, we believe steepening trades now represent a pain trade for the market," said Dhiraj Narula and team.

Option markets’ probability distributions show pricing for "right tail" risks of Fed hikes this year has risen markedly, a clear turn from the expectation of cuts at the end of February, further underscoring the vulnerability of flattening trades.

Other Pain Trades: European Stocks Outperform, EM Rates Fall, Russell 2000 Pullback

Besides the three core scenarios above, HSBC lists three other potential "pain trades". First, European stocks outperform US stocks. If the dollar strengthens gradually and not for safe haven reasons, it could drag down the overseas revenue repatriation of large US companies, while benefiting the more internationally oriented European stock market. Since the Iranian conflict erupted, Europe’s 2026 growth forecast downgrades have exceeded those for the US. If this trend reverses, European stocks could catch up.

Second, Emerging Market rates fall. HSBC’s latest sentiment survey shows net local currency bond exposure has dropped to -32% in EMs, with investors shifting to hard currency bonds. However, oil prices have fallen nearly 25% from their peak, and May CPI came in below expectations for most of the 22 EM economies surveyed; if inflation pressures continue to ease, the inflation and policy premium built into curves may compress, and EM duration assets could rebound.

Third, Russell 2000 rally stalls. The index is up about 20% year-to-date, beating the S&P 500 by roughly 12%. HSBC warns the Russell 2000's current valuation is at the 92nd percentile of its 30-year history, with its premium over the S&P 500 widened to 35%, far above the historical median of 18%. About a quarter of constituents are expected to post losses in 2026, and roughly 20% of small cap debt is soon due, facing higher-rate refinancing pressure. Net debt/EBITDA is about 5x, versus 1.6x for the S&P 500. If rate hike expectations heat up, small caps will be hit first.

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The above highlights are from ZF Trading Desk.

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