The steady grind higher in bond yields worldwide continues to be the central development for financial markets.
Unusually, this move has been stronger so far in the G10 countries than in emerging markets, though this gap is now beginning to close. In another departure from historical experience, equity markets have largely shrugged off the move, with US, European, and Japanese indices still close to record highs. Currency markets have maintained their composure thus far as well, but the dollar has emerged as the clear point of refuge for investors in the wake of the parallel sell off in government bonds globally.
Investor focus this week will be on two critical macroeconomic data points, both released on Friday. First, we will get the flash September inflation report for the Eurozone, where economists expect a sharp rebound in headline inflation that should validate expectations of at least one more hike from the ECB this year. Later that day, a week of US labour market reports will culminate in the release of the September nonfarm payrolls data. Given the fragility of the bond market, the US PCE inflation data the previous day may also move markets, especially in response to any upward surprise.
GBP
The PMI numbers out of the UK last week were a clear disappointment, in contrast with most of the real, albeit lagged data that we’ve received out of Britain of late. The contrast with the much better surveys in the Eurozone meant that sterling spent most of last week continuing its slow grind lower against the common currency. On the positive side, gilts are actually outperforming other sovereign bonds in relative terms, which is a pleasant departure from recent years, perhaps anchored by the highest yields in the G10.
Given the unsettled state of bond markets, next month’s Autumn Budget is emerging as the crucial risk on the horizon for UK assets generally. With yields surging, inflation rising and borrowing unexpectedly rising in recent months, Chancellor Healey is faced with an unenviable task. The government has already effectively signalled that further tax hikes and higher borrowing are coming, so the key for markets will be whether Healey can communicate this in a way that allays fears of a fiscal doom loop, while still convincing investors that the measures are credible enough to support growth.
EUR
A significant upside surprise in the September PMIs of business activity added to the narrative of strengthening Eurozone growth and a remarkable resilience in the face of the ongoing energy crisis. This week's flash inflation report should show a rebound in inflation in both the headline and the core index, further validating ECB concerns and the recent hawkish policy shift.
Amid the sell off in government bonds worldwide, French government bonds are having a particularly hard time, as the risk premium to German Bunds widens to levels last seen during the euro crisis in 2012. However, the ECB can take some comfort in that other peripheral spreads remain well behaved. Nevertheless, the French election cycle in 2027 will pose some unique tail risks to the common currency.
USD
The narrative of strengthening growth and stubborn inflationary pressures in the US will be tested this week by both the deluge in September labour market data and the PCE inflation report for August. Market pricing for over three hikes with a terminal Fed rate of nearly 5% strikes us as overdone, but we acknowledge that the sell-off momentum in fixed income markets generally makes it difficult to be contrarian.
With the Iran conflict far from showing any real prospect of resolution, the Fed putting to bed doubts about its independence, and the unsettling background of a worldwide sell off in bonds, the dollar seems to have found its footing. Another strong payrolls report on Friday would provide further support for the greenback as this could be enough to tip the scale in favour of a second Fed rate hike in as many policy meetings in October.
And don’t miss our next webinar tomorrow!
Bond market turmoil and the FX fallout: How to protect your margin
