Global bond market sell off deepens as investors fear inflation spike
The typically quiet month of August is now over, though it was not without intrigue and perhaps left in its wake more questions than answers.
Highlights:
- Bond yields surge worldwide as Iran war impasse sees oil prices jump.
- US dollar recovers ground as investors eye September Fed rate hike.
- FOMC chair Warsh strikes a hawkish note at Jackson Hole symposium.
- Euro Area inflation rises above 3%, but core inflation remains near target.
- Gilt yields surge amid market rout, UK borrowing fears.
- GBP volatility hits multi-year low – we think this is unlikely to last.
Without doubt, the dominant story across markets continues to be the broad sell-off in government debt worldwide, which has sent yields soaring to multi-year highs amid investor fears over rising deficits, ballooning AI-related borrowing, and the ongoing conflict in Iran – the latter having pushed oil prices surging back through $90 a barrel. For currencies, the fallout has been mixed. Higher US yields, coupled with some hawkish remarks from FOMC chair Warsh, have lent the dollar some support via rate differentials – even in the current low volatility environment – while commodity currencies such as the Australian dollar and Norwegian krone have performed well.
Tensions in the bond market are unlikely to dissipate any time soon, setting an intriguing backdrop for September. A cluster of central bank decisions are due in the coming weeks, with the ECB, Bank of Japan, and now even the Fed all set to weigh hikes against an extremely challenging backdrop of surging yields. For the dollar, the key question is whether the recent hawkish repricing has staying power, or whether it unwinds should incoming data – particularly on jobs and inflation – fail to keep pace with expectations. Either way, September looks set to test just how far central banks are willing to go to keep inflation risks in check.
USD
August turned out to be a surprisingly action-packed month for the dollar, which was buffeted first by the surprise news of an increase in the Treasury’s buyback operations, and then by notably hawkish remarks from FOMC Chair Warsh on Friday. Speaking at the annual Jackson Hole symposium, Warsh noted that while recent US inflation readings had been better than expected, the Fed would still have “work to do” if policymakers weren’t confident that underlying inflation was moving towards target clearly and at sufficient speed. The market’s response was a knee-jerk dollar rally late last week, which reversed most of the greenback’s month-to-date losses.
Warsh’s remarks have been enough to shift the dial dramatically: markets have pivoted from seeing a September Fed hike as fairly unlikely to now treating it as the base case. We are somewhat conflicted. While the ongoing war in Iran and elevated oil prices make a September hike plausible, the absence of second-round inflation effects, a cooling jobs market and the rise in Treasury yields (that Warsh himself has said partly does some of the Fed’s job for it) mean we’re not rushing to change our call for no change just yet. This may change, however, particularly as it may be difficult for the Fed to disappoint markets that now see more than a two-in-three chance of a hike later this month.
EUR
The euro surged up against the dollar for the first time in three months in late August, following the Treasury’s surprise announcement of expanded buyback operations, though EUR/USD has since settled back around our year-end target. While we remain constructive on the euro’s medium-term outlook, an aggressive push higher looks difficult in the near term as long as European natural gas prices keep climbing. Dutch TTF gas futures rose to a more-than-three-and-a-half-
Both the continued climb in gas prices and the increase in headline inflation – which jumped to 3.3% in August – all but dot the i’s and cross the t’s for a September rate hike from the ECB. Yet we note that a pass through from the energy spike to underlying inflation was still conspicuously absent in yesterday’s data, with the core figure stuck at 2.4% – just above target, and exactly where it was when the war began in February. While a September hike looks all but guaranteed, further tightening into restrictive territory beyond that is far from certain, and that could keep a lid on the euro, particularly given how aggressively markets are currently pricing in additional hikes.
GBP
UK domestic news flow was fairly light in August, reflecting both the usual parliamentary summer recess and a dearth of market-moving economic releases. The data we did receive reinforced a theme that has been building for months: Britain’s economy continues to expand at a surprisingly resilient pace, even as the labour market keeps deteriorating and borrowing costs continue to rise. Amid the absence of news, one-month implied volatility in GBP has fallen to more than twelve-year lows, though we expect that to prove a floor for some time given brewing budget jitters and the fact that August tends to be a low volatility month across financial markets.
Andy Burnham finally made his long-awaited debut in Prime Minister’s Questions on Tuesday, though it was remarks from the PM’s official spokesman earlier in the day – where he insisted that the government would stick to the fiscal rules with an unspecified headroom to spare – that carried more weight for markets. The big headache for politicians is the continued sell off and underperformance in gilts, which have seen the 10-year yield surge to an 18-year high above 5.2%. This rise in yields, which will eat directly into the government’s fiscal headroom, raises the risk of tax hikes in the autumn, even before accounting for any additional spending increases that Burnham seems likely to pursue.
