This week, we have seen a significant increase in bond yields in both the US and Europe. Markets are reducing expectations for rate cuts from central banks, which are now priced to happen only slowly. This follows signals from the central banks themselves that they are still ready to combat inflation which remains too high.
In our view, uncertainty over the economic outlook remains large, and we see a significant risk that the interest rate outlook will have to be adjusted lower again. There has been a serious tightening of financing conditions both in the US and the euro area, and the market move towards higher yields is tightening conditions further. Current market pricing implies a very soft landing for the economy, and history shows that such expectations are often too optimistic.
On the inflation side, we got the preliminary September data for the euro area, where the y/y inflation rate declined from 5.2% to 4.3%. This decline was largely driven by base effects, but the m/m increase in both headline and core price indices also declined and landed close to 0.2%, which is close to consistent with 2% annual inflation. This is a volatile measure but nevertheless good news for the ECB.
Large government borrowing is also behind the increase in bond yields. This week, we had downwards revisions to the outlook for public finances in France and Italy, but Germany lowered its estimated borrowing requirement for this year.
One reason behind higher bond yields could also be expectations of monetary policy tightening in Japan through an easing of the yield curve control. We agree that this is likely to happen in the not too distant future, however inflation in Japan slowed from 2.8% to 2.5% y/y in September. The quarterly Tankan business survey due Monday and wage data Friday will be key to judge the longer term inflation momentum.
In China, property developer Evergrande returned to the headlines with news that it had missed a bond payment and scrapped creditor meetings. This is not helpful to the efforts for revitalising home buying and hence the construction part of the economy, and is adding to concerns over growth. Note that the coming week is the Golden Week holiday in China.
A US government shutdown might be a reality from Monday if the US Congress fails to either pass a budget agreement or a resolution to continue with the old budget temporarily. A shutdown would mean a sharp reduction in government spending until it is resolved and could have a somewhat negative effect on growth if it lasts more than a few weeks, but it is not a threat to the US meeting its debt payments like the debt ceiling problem earlier this year was. Also, a shutdown would mean that government statistics such as the coming week’s job report and job openings are not published, whereas private sector data such as the ISM and the ADP employment report are not affected. If we do get data, it could be very important for whether or not the soft landing narrative persists.
On the central bank front, we will get rate decisions in Poland, Australia and New Zealand.
