US Treasury bond yields have continued to march higher over the past couple of weeks, keeping US financial markets on the edge. The 10-year Treasury yield in particular has caught the attention of traders, and for a brief period on Monday, it moved above 5% – a level not seen since just before the Global Financial Crisis in 2007. The two-year Treasury yield – which tends to follow the trajectory of the Fed fund’s rate – also nudged above the 5% level last week.
The US economy is now slowing faster than the data would suggest. The Fed has raised rates 11 consecutive times, and interest rates now stand at the highest we have seen in some 22 years – 5.25%. There is now a danger that the US could slip into recession at some point next year.
The bond vigilantes are not happy and are signalling their distaste for the Fed's current monetary and fiscal policies by selling off amid the prospect of higher-for-longer interest rates. Furthermore, it would not be a total surprise if the Federal Reserve Bank were to raise interest rates yet again in its bid to bring inflation down nearer to its 2% target. Whether or not that is the correct course of action is another debate.
Higher yields will increase the cost of borrowing. This, in turn, will put further downward pressure on stock market valuations and weigh on bond price returns. However, while government bond yields might overshoot in the short term, we would expect them to normalise over time – particularly when the US Federal Reserve Bank and other global central banks eventually pause their rate hikes and pivot lower.
Nevertheless, we still expect the US 10-year bond Treasury yields to remain elevated in the post-pandemic era. Indeed, the “new norm” appears to have it sitting within the 3.5% – 4.5% range, making today's yields (like cash deposits) rather attractive. And there is too much risk in the world to bet against bonds and current long-term rates.
The other major global event that has dragged the equity markets down is, needless to say, the Israel-Hamas conflict. More than two weeks after the series of coordinated attacks conducted by the Palestinian Islamist militant group on Israel, Iran has warned the latter of the wider consequences of any Israeli troops entering the Gaza Strip. The scale of the human tragedy has been devastating and, in the wake of the Gaza hospital explosion, diplomatic efforts have amounted to nothing.
From an economic perspective, any oil embargo against Israel (or indeed the West) would have far-reaching outcomes and would increase inflationary pressures at a time when taming inflation remains the core mission of leading central banks. A further period of volatility and uncertainty in the energy markets awaits as we enter the winter – a situation that is unlikely to change until next year.
Globally, the markets are evidently grappling with a significant number of unknowns. Although they seem to be more focused on long-term rates, a worsening of the situation in the Middle East could quickly change that. The risk of a full-scale war in the region is regrettably very real. The West will be closely monitoring oil prices and crude outflows. Any substantial increase in energy prices would significantly impact the central banks.
While crude oil and gold prices have offered something in the way of a safe haven, the relentless increase in interest rates has kept the yellow metal below the psychological US$2000 per troy ounce level. However, the non-interest-bearing precious metal could still rally higher if hostilities spread beyond the Gaza Strip. Normally, after a major political shock, investors tend to regard Treasuries and certain currencies (such as the yen) as a defensive shelter. Not this time.
In the UK, consumers are suddenly much more wary about spending money. Indeed, the drop in consumer confidence is not dissimilar to the one experienced in the early days of the pandemic, or indeed as a result of all the uncertainty surrounding Brexit. This is mainly due to the ongoing rise in everyday costs – heating and petrol bills, along with mortgages and other household expenditure.
Circumstances are likely to remain challenging for high street stores as we get closer to Christmas – a period when this sector traditionally looks forward to higher consumer spending levels. A reduction in spending would suggest that the UK economy is still going through a difficult time.
Last week, both the International Monetary Fund and the World Bank shared their findings at their annual meetings. Both organisations were rather despondent regarding the damage done to world economies and markets by inflation, wars and trade disruption. And both anticipate slower growth in the months and years ahead (2.9% global growth predicted for 2024). The growing gap between the world's poorer and its richer countries was another perennial concern that was discussed at the meetings: in the US, the post-pandemic recovery has been some stronger than in many other countries. But the key topic was the two wars currently being waged and the emergence of two major blocks, spearheaded by the US on one side of the equation, and China on the other.
The world will most likely muddle on through a global economic slowdown in the coming months created by central bank monetary tightening. But relatively loose fiscal policy will provide some offset relief. Further emphasis will be on national and regional security of supply, onshoring of investment and opportunities in the areas favoured with subsidies and government purchasing. There is also likely to be some trade disruption. The superpowers, meanwhile, will probably go to considerable efforts to prevent the Middle East and Ukraine wars erupting into even more dangerous conflicts.
As Israel readies for a ground invasion of Gaza, and Palestinian and Israeli civilian deaths continue to mount, a broader struggle for influence continues in the Middle East between the US and Iran. There can be little doubt that this will have far-reaching economic repercussions.
That said, the financial markets are likely to react more to fears in relation to unknowns (long-term rates and the resilience of the global consumer), rather than the horror of what is currently unfolding in the Middle East.
The good news is that we hope to see inflation and interest rates peak very soon – if they have not already done so. And although the third quarter earnings season for the S&P 500 Index is off to an average start, this week will see the corporate earnings season start to ramp up as a slew of big tech titans report their results. Whatever the outcome, the magnificent seven are likely to dictate how the markets react over the coming weeks.
The situation does indeed look somewhat gloomy right now, but do remember that we are always here to provide you with advice and counsel as and when you need it. One of the benefits of working with Investment Quorum is that we are with you all the way, navigating through the inevitable periods of uncertainty and volatility, and reminding you that better times invariably lie ahead. We very much hope that you will get in touch with us to discuss any concerns you may have.
