What’s going on in financial markets?

For some time now, it seemed like we were waiting for a recession to strike and global interest rates to fall. In the last few weeks, the narrative has shifted to higher for longer, and perhaps it will change once again to even higher for longer. The US economic data has ticked up in the past month, and as we mentioned in prior articles, this is adding to expectations that Q3 will have been a bumper one for the US economy. The question now is, where does the US economy go from here? Does growth fall off a cliff? Will interest rates actually move higher? What about geopolitical risks? Below, we will try to help you to navigate through financial markets in these challenging times.

The first focus is US growth. The Atlanta Fed’s GDPNow tool is estimating that Q3 GDP expanded by a whopping 5.4%. This estimate has a close relationship to the official BLS figure, which will be released in the coming weeks, and it suggests that the US economy was firing on all cylinders just a few weeks ago. Even real residential investment, which is expected to see its growth rate decrease from 5.5% to 4.8%, is witnessing a decent expansion. This estimate, based on actual economic data, is stronger than most analyst forecasts and cannot be ignored. The US economic data has surprised to the upside in recent weeks, with a turbo charged labour market report, strong CPI, better than expected retail sales and industrial production, which rose by 0.3% last month alone. The sustained strength of the US economy is fuelling a sell off in the bond market, the 10 year yield has risen by another 5 basis points on Thursday and is currently at 4.95%. The 10-year yield is up more than 25 basis points in the last 5 days. This level of volatility in the bond market, and in the world’s most important global financial benchmark, is going to impact risky assets. The surge in bond yields on Wednesday triggered a sharp sell off in the S&P 500 and in the Nasdaq. The S&P 500 was down 1.23%, with losses for all sectors except energy and consumer staples, typically defensive sectors.

The sell off could continue as the negative correlation between stocks and bond yields gains momentum. Currently e-mini futures for the S&P 500 shows a slight decline for stocks at the US open, however, the direction of travel will be dependent on what Federal Reserve Chairman Jerome Powell says at the Economic Club of New York later  today. Will Powell try and anchor the bond market, as the 10-year yield edges towards the key psychological level of 5%? The reason that yields are rising so fast is because there are no anchors for the bond market right now. The Fed is not providing leadership on monetary policy, as it says that it is data dependent. The economic data is subject to revisions and some have argued that the data’s accuracy is not adequate. Added to this, the Chinese investors sold more than $21bn of Treasuries and other US assets in August – the largest amount in 4 years. This is adding upward pressure to US bond yields, at the same time as the Federal Reserve, previously the biggest buyer of Treasuries, pivots to become a seller of US sovereign debt. The China sales also suggest that China is in economic trouble, with government agencies trying to sell USD in an effort to shore up the yuan.

Overall, rising bond yields is considered a negative for financial markets. This doesn’t look like it will be remedied any time soon, unless Jerome Powell says something on Thursday that eases the market’s fears. Will he try and anchor the bond market, by saying that the Fed will become less data dependent, and instead will look at the lagged impact of interest rate increases? This could go some way to calm the market, however, will it impact interest rate expectations? Currently, the Fed Funds Futures market expects rates to remain at 5.25-5.5% when the Fed meets next month. However, expectations for December are more finely balanced, with a 40.8% chance of a 25bp rate hike in December. Chairman Powell’s speech on Thursday, could trigger a wave of volatility in the Fed Funds Futures market, which may have a big impact on stock markets and on the dollar.

Another theme that is running through financial markets right now is geopolitical risk and the war between Israel and Palestine. The leaders of the US and the UK have been to Israel this week, to pledge unwavering support to Israel for the duration of this war. While the humanitarian costs on both sides are horrendous, the financial markets have been less impacted. For example, the spot Brent crude price is down more than 1% on Thursday at $90.70 p/b. New supply from Venezuela, along with excess supply in Saudi Arabia due to production cuts, is soothing market concerns. The Vix index, which is Wall Street’s fear gauge, also has not spiked in recent weeks. It is currently below the 20 level, which is lower than the 26 level reached in March when SVB bank failed. The relative stability in the Vix index could be down to two reasons: 1, the oil price has remained fairly contained, even though the war is taking place in the Middle East, a region that is vital for oil production, and 2, the market does not know how to price geopolitical risk. Thus, if geopolitical tensions escalate, we could see volatility surge.

It is also worth watching gold, which is up 4.39% in the past 5 days. This suggests that investors are concerned about geopolitical issues and the prospect of higher levels of inflation, even if the Vix is stable. However, the gold price is still below the key $2,000 p/ounce level, which suggests that markets are still relatively calm, even if they are buying gold for insurance purposes.

Looking ahead, Fed speak will determine what markets do next, we will be sure to fill you in on their messages later this week.