Risk assets under pressures as bond yields keep rising

Saxo UK Investor Strategist, Neil Wilson.

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Andy Burnham spoke to MPs in Parliament as PM for the first time yesterday. He must be cursing financial markets as the blowout in government bond yields – which is a global phenomenon – makes the arithmetic for his new Chancellor all the tougher ahead of the Budget at the end of October. There will be less fiscal headroom, less room to raise spending and no chance to borrow much more – the pressure to tackle a couple of sacred cows (like the triple lock) will grow. Crises can shift the Overton Window – the rapid rise in gilt yields is not a crisis yet but it could start to become one if it gets much worse and risks further undermining Britain’s fiscal position just when it might need more room.

Bond yields keep going up and the pressure on risk assets ratchets up further. Fresh multi-year/multi-decade highs for government bond yields this morning reflect inflation expectations and fiscal policy risks with a fresh flareup in the Middle East layered on top. The escalation in the Middle East comes swiftly after the Federal Reserve chair, Kevin Warsh, sounded more hawkish than many had expected. Markets have started to lean towards a September rate hike, with implied odds for the Fed to raise rates by 25bps up to 70%. The dollar has firmed to a two-week high and rising real yields are pressing on gold, which slid to its lowest in almost a month.

There are lots of reasons for the blowout – the unclear fiscal outlook across developed countries and rising deficits, layered with a belief/fear that they just can’t/won’t stop spending like drunken sailors; (case in point) the US is running super-loose pro-cyclical fiscal stance with 6% deficit with economy at full employment; AI capex debt boom competing for demand and sucking capital away from government bonds; increased military spending, both real (the US needs to spend a lot more to replace what it spent in Iran) and expected (Europe is slowing piling into defence spending); a shift from price-insensitive buyers (institutions) of bonds to price-sensitive (private); rising inflation expectations both in near-term (war, supply disruptions) and longer term…due to fiscal dominance fears – that central banks keep policy rates lower (financial repression) to finance the ever-growing debt pile. There are fewer ways out… governments could get control of spending, and central banks could show unbreakable resolve to fight inflation through a more hawkish policy stance. The former is not going to happen without a political reset or crisis. The latter is considerably more feasible.

Eurozone flash headline inflation rose to 3.3% year-on-year in August from 2.9% in July, the highest in close to three years, driven mainly by energy.  It cements a September rate hike by the European Central Bank, particularly as the Eurozone economy has held up so well in the teeth of the US-Iran war – Germany’s manufacturing PMI was revised up to 54.3, the strongest since May 2022, on stronger new and export orders.

Stock markets are entering September in a pretty standard fashion; with a selloff, one that often that leads into an October-to-yearend rally for equities. September is seasonally the worst month for US equities and I think the spike in bond yields will drive further losses before it stabilises. European markets faded early Wednesday by around 0.4% after steeper losses in Asia overnight with the Kospi -4% and and Nikkei -3%. Tuesday had seen the Nasdaq down -1% and S&P 500 decline -0.7%. Higher bond yields make duration equities like the entire tech complex less appealing. The risk is a doom loop for risk assets (sounds perhaps a bit mawkish but certainly could offer tactical entry points) as higher bond yields force selling of equities (particularly higher duration stocks like tech) as bonds don’t act as a hedge, which in turn forces further liquidation/deleveraging.

Oil prices rose as the US and Iran traded a fresh round of military strikes, with Brent spiking to $97 before paring gains a touch to trade around $95, still a 5-week high. A deal could be in the offing at any point but at present it doesn’t seem either side is desperate to back down. Brent crude prices nearing $100 is one thing – but we don’t use crude oil, we use refined products and it’s here – due to a lack of refining capacity and constrained supply of crude – where the stagflationary risks abound – diesel trades at $200 a barrel, effectively a 100% premium to a barrel of crude. Don’t miss the Week Ahead here.