Treasuries Still Attractive

MACRO FRAME

September’s CPI and PPI data continue to fuel expectations of a new hiking cycle from the Fed, while higher interest rates are adding to stress in credit markets.

STOCK INDEX FUTURES

Equity index futures were mixed overnight. Stress at highly leveraged infrastructure providers is exposing the divide between cash-rich hyperscalers and borrowers dependent on continued access to credit. Government bonds rallied while equities sold off on Wednesday and Thursday even after an upside US inflation surprise. The reaction suggests that concerns over leveraged AI investment are outweighing the inflation picture, as Treasury yields above 5% offered enough income to attract defensive demand. Credit default swaps related to AI companies are in focus as a large sentiment driver after having hit record highs this week amid investor worries over cash generation. Inflation and higher interest rates are compounding the negative effects on credit stress, adding to concerns over debt-issuance and subsequent revenue generation. September’s inflation data raises the hurdle for equities; the pickup in core prices and more specifically core services prices furthers the case for tighter monetary policy. Meanwhile, geopolitical events in the Gulf point to elevated upside risks in oil and diesel prices.

Given that the path of least resistance to the rates environment appears upwards over the next 6 months, support for equities increasingly relies on strong earnings support from big tech. Bank of America’s October fund-manager survey found that 37% of respondents would consider shifting from stocks to bonds at a 6% 10-year Treasury yield, with another 22% requiring 6.5% or higher. That leaves more emphasis on semiconductor names, who despite only accounting for 19% of the S&P 500’s weight, make up 35% of expected aggregate earnings growth this year. Thus, downside risks to the indexes stem from the prospect that higher yields will slow down the capital-spending cycle and demand for chips. However, demand for chips and memory supply across the AI infrastructure build out has shown a disregard to higher rates, which could underpin earnings growth and keep the indexes broadly resilient to a higher rates environment. Still, over the longer-term the market should not discount the risk of strong interest-rate headwinds.

Watch point: Despite tech volatility, the earnings backdrop suggests bullishness, despite the advent of a new hiking cycle.

CURRENCIES

US DOLLAR: The USD index fell 0.25% to 101.74. The currency market has been assessing the impact of Wednesday’s AI sell off, noting that the market’s moves may be a hint of the reaction function to a major AI-driven selloff, with the dollar falling instead of attracting safe-haven demand. A reduction in the outlook for AI investment would likely reduce bond supply and damage US growth prospects, resulting in demand for Treasuries and a lower-rate environment. The dollar index looks to be finding strong resistance at the 102.50 level. Money markets assign a 15% probability of a hike this month, compared with 20% before September’s inflation data.

Watch point: While current fiscal, macro, and geopolitical factors favor the dollar, it is beginning to enter overbought territory and could be susceptible to a modest correction.

EURO: The euro rose 0.20% to $1.1240. Eurozone CPI was confirmed at 3.8% y/y in September. French fiscal risks still remain a key headwind for the euro, with recent gains coming from dollar weakness instead of a fundamental change in the fiscal outlook for France. ECB President Lagarde said energy-driven inflation had yet to spread across the broader euro-area economy; ECB policymaker Šimkus warned that further rate hikes could be necessary as price pressures continue to build, adding that an increase as early as this month remained possible. Any slowing of its tightening cycle could further weaken the euro’s relative rate support.

Watch point: French sovereign stress will continue to be a dominant factor in price direction, however, the $1.10 level acts as a strong resistance level.

BRITISH POUND: Sterling is 0.41% higher against the dollar at $1.3330. Better-than-expected UK data is set to snap the currency’s four-week losing streak against the dollar. The economy’s resilience gives the Bank of England room to raise rates before year-end without putting additional pressure on an already weakening economy. In a Reuters poll, 54 of 63 economists expect the BoE to raise rates by 25 bps to 4.0% in November, although did not reach a majority view in favor of another increase afterward; markets are pricing four quarter-point moves by the end of 2027. Governor Andrew Bailey voted to hold in September but warned that a prolonged energy shock and stronger second-round effects could make tighter policy necessary. The Office for National Statistics said GDP in the UK rose 0.1% in August, as the AI-related tech sector contributed to growth. Consensus forecasts had expected a 0.1% drop. Still, there may be some more headwinds for the economy further into the year as higher energy prices eat into household incomes and spending. Elsewhere, finance minister Healey said Britain’s new budget would include measures to counter the energy price shock and reiterated that the budget will meet fiscal rules.

JAPANESE YEN: The yen is little changed at 158.08 yen per dollar. Bank of Japan Governor Ueda overnight reiterated the risks of underlying inflation overshooting the central bank’s 2% target, stressing the growing importance of keeping price pressures anchored around that level. This comes after BOJ board member Koeda cautioned against restraint in raising rates, implying that the central bank could remain on track for further rate increases in the coming months. Earlier reports indicated that the BOJ was hesitant to implement an unusual back-to-back rate hike this month, while still considering a potential increase in December. Markets now price 18 bps of tightening be year-end. The currency remains under pressure from US rate differentials and a market that is unconvinced the central bank will raise rates in a timely manner. The greatest near-term upside risk for the currency remains market intervention.

Watch point: While markets are underwhelmed at the BOJ, a path for additional rate hikes looks to be  appears to be the primary scenario.

AUSTRALIAN DOLLAR: The Aussie 0.52% to $0.6955. Market focus is on third-quarter inflation data next Thursday following soft jobs data that showed employment fell 39,300 in September, the largest in a year and expectations of a rise of 20,000. The unemployment rate held at 4.7%. Market expectations of a November hike have been are at 25%, while a move in December is priced at 42%. The drop in labor market conditions should give the RBA some more confidence that policy settings are adequately restrictive.

Watch point: August’s hiring figures argue for a higher-for-longer stance, leading the focus to Q3’s inflation data.

TREASURY FUTURES

Yields edged higher across the curve. This week’s price action has shown there are plenty of buyers for US debt at yields of 5.2% for 10 years. Treasuries are also regaining some defensive appeal as investors reassess the debt surrounding the AI buildout, the main signal being the rally in Treasuries despite the hot CPI and PPI prints this week and the Fed’s October Beige Book revealing intensifying input-price pressure, including higher oil and diesel costs moving through freight and supply chains. Market pricing for an October Fed rate hike is 15%, while a December hike remains fully priced in. Over the next 12 months the market expects 78 bps of tightening.

September’s inflation data represents a two-layered inflation problem: higher energy costs and firmer services prices that are complicating disinflation. Our base case is that the Fed will need to raise rates two to three times over the next 12 months to effectively combat inflation. While the hawkish Fed has led the curve to flatten amid contained inflation expectations, we continue to see upside risk to long-term borrowing costs if growth remains resilient. For now, we expect that the dramatic rise in longer-term borrowing costs has been has been overdone and that the market is set to embark on a slower rise toward higher long-term yields.

Watch point: Inflation risk, fiscal and corporate supply, capital competition and term premium will be key factors in determining whether the yield curve maintains its recent flattening or falls into a bear steeping move.

Interested in more futures markets?  Explore our Market Dashboards here.