Weekly Investment Commentary: Bond jitters

Weekly economic update from Rupert Thompson, IBOSS Chief Economist, part of Mattioli Woods, where he analyses market reactions to recent events and identifies upcoming market trends in global markets, including in equities, fixed income, FX, etc.

In today’s piece, Rupert looks at:

• Oil prices: These resumed their upward climb with Brent crude rising to $97 per barrel as the stalemate continued with no sign that either the US or Iran are yet willing to back down. European gas prices are hitting their highest levels since the start of 2023 as nervousness grows over the relatively low storage levels ahead of winter.
• In the UK: The rise in gas prices is unwelcome news for the UK and will add to the upward pressure on inflation later in the year with UK electricity prices unnecessarily dependent on gas prices. Bond yields, however, are the biggest source of angst. The 10-year gilt yield touched 5.28% last week, the highest level since 2008, before slipping back to 5.15%, and is up 0.6% since the start of the year. This can only add to the pressure on the Chancellor to raise taxes in the October Budget – both to finance any increased spending commitments and restore the fiscal headroom.
• In the US: The 10-year US Treasury yield has risen 0.6% this year to 4.8%. The key question is whether this upward march in yields will continue or whether most of the bad news is now priced in, which is IBOSS’ view. A 0.25% hike at the Fed meeting on 17 September currently hangs in the balance. US payrolls on Friday came in considerably stronger than expected easing the fears of a softening in the labour market. This leaves inflation looking set to be the key to the Fed decision, with this coming Friday’s August numbers taking on additional importance. Either way, we are only looking at one or two US hikes at most over coming months, and this is now priced into the market, so should not be a source of further upward pressure on yields.
• This coming week: US inflation data on Friday will be the main centre of attention. The ECB meeting will also be a focus with a 0.25% rate hike looking likely. Finally, UK GDP numbers for July are out on Friday.

Bond jitters

Last week was another quiet one for equity markets at least. Global equities edged down 0.1% in local currency and up 0.5% in sterling terms. Most markets saw modest gains although the UK was down fractionally and Japan was up 1.8%, buoyed by a strengthening of the yen on speculation of renewed intervention by the authorities.

Bond markets, by contrast, remained in the headlines with government bond yields hitting multi-year and in some cases multi-decade highs early on in the week. But yields subsequently fell back a little, ending the week up modestly in the US, flat in the UK and down slightly in Japan.

Meanwhile, oil prices resumed their upward climb with Brent crude rising to $97 per barrel as the stalemate continued with no sign that either the US or Iran are yet willing to back down. But it was European gas prices which were more in the news, hitting their highest level since the start of 2023 as nervousness grew over the relatively low storage levels ahead of winter.

Gas prices are up 150% since the start of the year although remain under half the levels seen during 2022. Still, this is unwelcome news for the UK and will add to upward pressure on inflation later in the year with UK electricity prices unnecessarily dependent on gas prices.

But it is bond yields which are the biggest source of angst. The 10-year UK gilt yield touched 5.28% last week, the highest level since 2008, before slipping back to 5.15%, and is up 0.6% since the start of the year.

This can only add to the pressure on the Chancellor to raise taxes in the October Budget – both to finance any increased spending commitments and restore the fiscal headroom. The latter has probably halved from the £24bn left by Rachel Reeves because of the rise in borrowing costs and other factors.

Much more important for markets generally, however, is the outlook for the 10-year US Treasury yield, which has also risen 0.6% this year to 4.8%. The key question is whether this upward march in yields will continue or whether most of the bad news is now priced in, which is much more our view.

Yields have been driven higher by three main factors – as we discussed in some detail two weeks ago: the credibility of Fed policy coming under threat; the dismal US fiscal position; and the increased competition for investor funds from the ton of debt now being issued to finance AI-related capital spending.

The second and third factors look set to remain in place but arguably the first factor is currently the most important. And Fed Chair Kevin Warsh has gone some way to restoring his credibility after a dismal start to his Chairmanship – restating in late August the Fed’s iron-clad commitment to its 2% inflation target.

A 0.25% hike at the Fed meeting on 17 September currently hangs in the balance. Chris Waller, a senior member of the Fed, stated last week that he favours keeping rates unchanged – just as the market had started to convince itself a hike was on the cards following Warsh’s August speech. So much for Warsh’s plan for reduced and less confusing forward guidance.

US payrolls on Friday then came in considerably stronger than expected, easing the fears of a softening in the labour market caused by the previous month’s unexpectedly weak numbers. This leaves inflation looking set to be the key to the Fed decision, with this coming Friday’s August numbers taking on added importance.

Either way, we are only looking at one or two US hikes at most over coming months and this is now priced into the market, so should not be a source of further upward pressure on yields. Crucially – despite all the headlines and the recent misjudged intervention by US Treasury Secretary Bessent – there has been no disorderly jump higher in yields or sign of panic. 10-year US yields are merely back towards the top end of their trading range since 2023 which saw yields reach a high of 5.0%.

The relatively orderly move higher in yields is one reason why we don’t believe it will de-rail equities. Equally important, despite no early end to the disruption in energy markets in sight, economies around the world have proven more resilient than expected and growth looks set to continue to hold up reasonably well.

Equity valuations have also already de-rated significantly, leaving them less vulnerable to higher bond yields. The global price-earnings ratio has fallen back to 16.8x. This remains 5-10% above the long-term average but is down significantly from a high of 19-20x seen in the second half of last year.

Finally, equities usually respond to the start of Fed tightening with a pause or small decline for a few months, only then to resume their earnings driven upward trend – as long as the rate hikes don’t cause a recession, which currently looks unlikely.

This coming week, US inflation data on Friday will be the main centre of attention. The ECB meeting will also be a focus with a 0.25% rate hike looking very much on the cards. Finally, there are UK GDP numbers for July out on Friday.