Last week ended for equity and bond markets, at the headline level at least, very much being a repeat of the previous week. Government bonds posted losses of 1% or so as 10-year UK and US yields climbed another 0.1-0.2%, with US yields touching a mid-week high of just under 4.9%.
Meanwhile, global equities posted another small decline. Markets ended the week down 0.3% in both local currency and sterling terms, albeit with rather larger daily moves along the way.
The latest batch of US economic data was the main source of market-moving news and was a consistent story of unexpected strength. Manufacturing confidence recovered more than expected in September and job openings posted a surprise rebound in August. But the biggest surprise came on Friday.
US jobs grew by close to double the amount expected in September, posting the largest increase since January, and gains in previous months were also revised up. Yet the unemployment rate was unchanged at 3.8% and wage growth slowed a little further to 4.2%.
The continued strength of the economy, particularly the labour market, has reinforced the market’s belief that interest rates will have to remain higher for longer, as the Fed has repeatedly been saying. All the same, it still believes the Fed will most likely hold off raising rates again in early November.
The favourable inflation news of late is one reason to believe this, but so too is the rise in bond yields. This itself represents a tightening in financial conditions and is doing some of the Fed’s work for them.
As to what is behind this latest ratchet higher in yields, the ‘higher for longer’ narrative is probably the most important factor. But upward pressure is also coming from renewed concerns over the large amount of government debt needing to be absorbed by the market. Not only is the US budget deficit running at a high 7-8% of GDP but also the Fed continues to unwind its holdings of government bonds via quantitative tightening.
Events in the Middle East have taken a terrible turn over the weekend. However, the market reaction has been small with equity markets and bond yields both down a little. The reality is that the ramifications are likely to be limited unless the conflict widens out to include Iran which would then threaten oil supplies.
Crude oil prices are currently up no more than $3 or so on the news and at $87/bbl, the Brent price is actually down $8 over the week. Concerns over the strength of oil demand led to the price unwinding last week almost all of the previous run-up resulting from Saudi Arabia and Russia extending their output cuts.
Bond yields have risen further than almost anyone expected. But with monetary tightening now all but over, even if rates are set to remain higher for longer, yields should finally be at or very close to their peak. This in turn suggests losses from fixed income should now be largely behind us and that bonds should soon start to deliver their best returns since the global financial crisis.
The rise in bond yields has recently put global equities under some downward pressure and they are off some 5% in local currency terms and 2% in sterling terms from their July high. However, with markets still up 11% and 8% year-to-date respectively, despite bond yields rising this year as much as 1%, the bigger picture is one of resilience.
The key support has come from corporate earnings which have held up much better than feared as recession worries have so far proven unfounded. The third quarter reporting season kicks off on Friday in the US with the large banks and will be a major focus to see if this support remains intact. Earnings are forecast to post a gain of 1% on a year earlier, up from the 3% decline seen in the second quarter.
While corporate earnings and developments in the Middle East look set to take centre stage for the next few weeks, inflation developments will remain critical for much longer. Indeed, Thursday sees the release of the US inflation numbers for September. Headline and core inflation are expected to be 3.6% and 4.1% respectively, well down from their highs but still way too high for the Fed’s liking.
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