The relentless sell-off in government bonds worldwide remained the dominant force in financial markets last week.

The 10-year Treasury yield rose to its highest level since 2002, and the US Dollar Index gained as a result. If it wasn’t already abundantly clear, we are now witnessing a flight to safety episode, as the dollar rallied in spite of softer inflation and jobs data that has pushed back market expectations of Fed hikes - as witnessed by the fact that the best performer for the week was the Swiss franc. Oil fell sharply after the G7 agreed on an emergency release of crude and diesel, yet yields kept rising, a further sign that this rout is now driven by the growing risk premium attached to sovereign debt with increasingly shaky fundamentals.

This week is light on data, which leaves the bond market firmly in the driver's seat. The minutes of the September Fed meeting on Wednesday will show how much conviction there was behind further hikes, though they predate the weak payrolls report and soft PCE inflation data. The account of the ECB's September meeting follows on Thursday. Markets will also focus on the US Treasury's buybacks of long-dated bonds, a series of bond auctions and a string of Fed speakers starting on Monday.

GBP

Sterling was one of the more resilient currencies last week, trading roughly flat against the dollar and up to a two-month high against the euro, as the debacle in the French bond markets made British assets look comparatively safe. That resilience was only relative, however, as we saw another leg down in gilts, with the 30-year yield touching 6% for the first time since 1998 - a move that will continue to eat into the Labour government’s fiscal headroom ahead of the highly anticipated Autumn Budget at the end of the month.

The pound also continues to be well supported by resilient domestic data, with last week’s revised GDP figures showing that the UK economy grew at a faster pace than initially anticipated in the second quarter. While we still contend that a slowdown appears likely in the coming months, the stubbornness in demand in spite of downside risks is nonetheless commendable. There is little UK data to watch this week, so attention turns to the run-up to the 28th October budget, which is the key risk for both gilts and the pound. The EUR/GBP cross rate will, however, highly likely remain wholly dependent on developments in France.

EUR

The common currency had a rough week due to unsettled trading in the French bond market, which spilled over into the other peripheral bonds by the end of the week. A higher than expected September inflation print, 3.8% against a 3.6% consensus, did nothing to help the common currency, particularly after the surprisingly dovish remarks from ECB President Lagarde during the week, which have made clear that the bar for an October rate increase from the Governing Council is now very high indeed.

For now, the worries remain squarely focused on France, whose sovereign yield spread to German Bunds blew out to the widest since the Eurozone crisis in 2011 following the largest weekly widening in said spread in seventeen years. By week's end we saw hints of a stabilisation in both bond markets and the common currency, though these fears are unlikely to go away given that the political deadlock in Paris remains very much unresolved after PM Lecornu’s budget proposals were met with scepticism from the fiscal watchdog. In the absence of key economic or monetary policy news, French political developments and the bond market reaction to them will remain key.

USD

Our view that market pricing for a long series of Fed hikes was overdone was vindicated last week. Core PCE inflation came in at 3.0% for August against 3.3% expected, and September payrolls rose by only 29k against expectations of around 85k, with 60k in downward revisions to the previous two months of data. Just as we discounted somewhat the strength of the previous report, we will not worry too much about this month's weakness, and note that the three-month average of net job creation remains around the 50k level, which appears sufficient to maintain a steady level of unemployment.

The greenback was unfazed, however. Unlike the US-led sell-offs of the past 18 months, when doubts about American policy dragged the dollar lower, the current rout is global and increasingly about fiscal credibility in places like France and the UK. Market skepticism about government finances seems to have spared the US so far, at least in relative terms.

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