A number of factors have accumulated to turn bondholders anxious: the prospect of higher energy prices for longer, evidence of second-round effects, and political instability in places like the UK. Harder to gauge, but nevertheless at the back of every investor's mind is the absence of progress in reducing deficits in the advanced economies and the prospect of an endless supply of fresh government debt - a trend worsened by demography everywhere. Equities are proving relatively resilient to the sharp rise in rates. Not so currencies. Every single major currency lost ground against the dollar, with the pound and the Brazilian real being notable underperformers due to domestic political turmoil.
The macroeconomic and policy calendar is relatively light this week. This means that following the bond market reaction to this week's sell-off will be very informative, whether bonds manage to find a floor and rebound or whether the sell-off continues in the absence of news. The main focus will be on the publication of the PMI leading indicators of business activity worldwide on Thursday. The UK will see critical labour market and inflation data, but the real focus will be on the perilous future of PM Keir Starmer.
USD
A couple of unpleasant surprises in the US inflation releases for April added fuel to the bond market sell off that had begun in the UK. Consumer inflation rose more than expected, and price pressures seem to be spreading from the energy sector to the core subindex. Producer prices also blew away expectations, as inflation pressures spread through the supply chain. Talk of interest rate cuts in the US has all but ceased, and markets are increasingly confident that the next move in rates will be up; the main uncertainty is when exactly that will happen.
A notable aspect of this bond sell off is that long term inflation priced in by markets is starting to move up, an unsettling development for the Federal Reserve. Incoming FOMC chair Kevin Warsh was formally appointed last week, with the June Fed meeting being his first at the helm. We think that Warsh will have a very tough time getting any of the hawks on side, meaning that the main fear for investors will probably be his push to move away from providing forward guidance.
GBP
The bond market sell-off started in the UK on fears that Starmer would be replaced by an even more fiscally irresponsible government after Labour's local election debacle, though it quickly spread to other G10 countries. The pound was hit in sympathy, losing ground against every major peer last week. The sole saving grace for sterling is that economic data has held up reasonably well. The economy grew at a solid pace of 0.6% in the first quarter of the year, and the latest PMI figures so far point to only a modest hit from the Iran war uncertainty.
This week's deluge of data will test that. We particularly look forward to the reaction in business confidence to the political instability. The pound has sold off to the extent that it is already assuming significant political instability, but a new leftist turn in the government would probably bring about a further selloff. Greater Manchester Mayor Andy Burnham, who will first need to win his byelection in Makerfield, is now the bookies favourite to replace Starmer. We think that Burnham would be the worst case scenario for gilts and the pound given both his preference for higher borrowing and taxes and his previous remarks that have dismissed the need for the government to be beholden to the bond market.
EUR
The sell off in bonds has now spread to the front end of the US curve, which means that interest rate differentials between the Eurozone and the US have not shrunk further for the last two weeks. We view this development as one of the factors driving the recent downdraft in the common currency relative to the dollar. The other two factors are the natural flight to safety brought about by the Iran war and the fact that the energy price spike seems to be impacting the Eurozone economy much more heavily than the US.
We now look ahead to this week's preliminary PMI releases for May to see whether there are any ongoing effects from the energy price spike on Euro Area business activity. Economists are pencilling in a modest rebound in the composite index, albeit to levels that are still consistent with an outright contraction in the bloc’s economy. Our assumption is that we’ll see a period of effective stagnation in the second quarter, although it's also hard not to construct a plausible scenario whereby Q2 growth dips into negative territory.
Deep dives and expert insights:
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- CEE FX Outlook - May 2026
- Asia FX Outlook - May 2026
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