Higher rates put market resilience to the test
4 mins to read this article
What matters to you in 30 seconds
-
US inflation data and higher oil prices have reinforced expectations that interest rates may remain higher for longer, keeping pressure on government bonds.
-
Equity markets have remained resilient, but corporate earnings are becoming increasingly important as higher bond yields make valuations harder to justify.
-
Current developments support our cautious view on US Treasuries and do not, by themselves, warrant a change to our broader positioning.
Bond markets
Inflation and yields move higher
August’s US inflation report presented a mixed picture. Annual headline inflation remained at 3.4%, while core inflation (which removes volatile items like food and energy) eased slightly to 2.4%. However, the monthly core increase of 0.3% exceeded expectations, suggesting some renewed pressure beneath the surface.
We think this strengthens the case for a September US Federal Reserve (Fed) rate increase, reinforcing expectations that interest rates may stay higher for longer.
The report supports our previously published expectation of a Fed rate hike, but guidance beyond September may prove just as important as the immediate decision.
The relatively muted response in longer-dated Treasury yields after the inflation release suggests that much of the adjustment had already taken place. G10 yields rose across the board, with the 10-year US Treasury yield climbing around 18 basis points over the week. Renewed strength in oil prices added to the concerns about inflation and further monetary tightening.
Oil approached USD110 per barrel on Friday before falling back to USD104 in early trading, as reports of efforts to restore shipping through the Strait of Hormuz provided some relief. Despite the pullback, oil remained around 10% higher over the week.
Yet an interesting contrast emerged earlier in the week. One-year inflation swaps were around half the level seen when oil first reached USD100 per barrel in March, suggesting investors were pricing a smaller inflation shock than at the outbreak of the Iran conflict.
Europe has already responded. On Thursday, the European Central Bank (ECB) announced a quarter-point increase in its deposit rate to 2.5% and published projections showing inflation remaining above target through 2028. Policy decisions will continue to depend on how economies balance persistent price pressures against the risk of weaker growth.
Energy is not the only influence on bond markets. The market’s muted response to the latest Treasury buyback operation highlighted the limits of official support. While buybacks may support bond prices, they cannot remove the underlying fiscal and inflation risks. This means they are unlikely to change the direction of bond markets on their own.
For investors, higher bond yields matter because they make lower-risk assets more attractive, which can put pressure on equity valuations. A 5% Treasury yield is not necessarily a tipping point, however. The speed and cause of the increase, together with the strength of earnings, matter more than the number itself.
Oracle’s stronger-than-expected results also provided a reminder than corporate earnings remain supportive in some areas, particularly those linked to cloud computing and AI infrastructure.
Positioning
Constructive, with greater scrutiny on earnings
Our recently published Counterpoint positioning provides the starting point, with a moderate equity overweight, preferences for US and emerging-market equities, caution on US Treasuries and an overweight in gold.
This week’s developments do not materially change our investment view. They reinforce our cautious view on Treasuries and increase the importance of earnings for the equity outlook. That said, a more persistent rise in inflation, a sharp increase in yields or a deterioration in profit expectations would provide stronger grounds to reassess the balance of risks.
This week
Central banks in focus
Attention now turns to decisions from the Fed, Bank of England and Bank of Japan. Following the firmer US inflation reading, markets increasingly expect a September Fed hike, while guidance on subsequent moves likely to be equally important. In the UK, market pricing implies around a 70% probability of rates staying as they are, with uncertainty ahead of the October Budget giving policymakers reason to wait. In Japan, markets view a quarter-point increase as a highly likely, with attention turning to signals about the pace of further tightening.
UK inflation and US retail sales data will provide further insight into inflation pressures and consumer resilience. Mainland China’s retail sales data and wider activity figures will also be closely watched to assess the balance between domestic demand and export-led growth.