Weekly Market Review

Bond yields: the risk is disorder, not simply rising

The latest data do not suggest that the global expansion is running out of momentum. Mid-month PMI surveys in the US and eurozone improved further, while US growth, employment and consumer spending indicators remain resilient. Against that backdrop, the case for tighter monetary policy has strengthened: inflation remains too persistent for comfort, and a further rate rise or two would not necessarily be enough to derail activity.

The issue for markets is less whether interest rates move modestly higher, and more whether bond yields continue rising in an orderly way. Central banks have been slow to respond to renewed inflation pressure, perhaps unsurprisingly given the supply-side nature of the shock. They are now in a challenging position – government borrowing remains high; inflation expectations are sticky; and there are few signs of the deflationary forces anticipated this time last year. If investors demand a higher risk premium for holding bonds, yields could overshoot and put pressure on equities, credit and other risk assets.

A gradual rise in yields can be absorbed if earnings continue to grow and economic activity stays firm. A disorderly rise is more problematic. It would challenge equity valuations, particularly in the more expensive parts of the market where expectations are already high, including US and technology-related exposure. It would also reduce the appeal of lower-quality credit (bonds, loans, or debt issuers that major agencies rate below investment grade), where spreads may not fully compensate investors for tighter financial conditions.

We remain constructive on the economic and corporate backdrop, but increasingly alert to the risk that bond markets become the transmission channel for a broader risk-asset correction. In our view, tighter developed-market monetary policy is justified by the combination of steady growth and persistent inflation. However, the balance of risk would change if yields continued to rise sharply from here. The political landscape for the US and UK also becomes increasingly relevant over the next 12-18 months.

With the midterm elections approaching in the US and approval ratings for President Trump low; the risk of the Republicans losing the House of Representatives has risen. Senate control remains finely balanced. A divided Congress could constrain fiscal policy and complicate negotiations around spending, borrowing and trade. In the UK, higher borrowing costs reduce room for manoeuvre for Prime Minister Andy Burnham and Chancellor John Healey. The upcoming Labour Party conference should provide more insight into the government’s priorities for this parliament, but fiscal uncertainty is likely to remain an important market focus in the short to medium term.

The key indicators are inflation data, wage growth, central bank guidance and the behaviour of longer-dated bond yields. Energy prices are also key: even if crude stabilises, tight diesel and refining markets could keep cost pressures alive. For now, the foundations of the expansion remain intact, but the margin for error is narrowing.

United States

The US investment backdrop remains a contest between economic resilience and the pressure created by higher borrowing costs. Firm household demand and continued corporate investment have helped support activity, while the market is paying increasingly close attention to whether earnings growth can keep pace with valuations. The rise in long-dated Treasury yields matters because it affects mortgage rates, business financing and the relative appeal of equities, particularly companies whose expected profits lie further into the future. This week's inflation, GDP and employment releases should help clarify whether the economy can continue to expand while monetary policy remains restrictive. Investors are also watching how the benefits of technology investment spread beyond the largest companies. A broader earnings recovery would provide a healthier foundation for the market, whereas disappointing inflation or labour-market data could prompt renewed volatility.

Europe

Europe enters the week with an improving activity picture but little room for complacency on inflation. Better business surveys suggest that the region has retained some economic momentum, although higher energy costs, elevated government borrowing and rising sovereign yields remain challenges for policymakers and businesses alike. The forthcoming eurozone inflation release will be particularly important in shaping expectations for the European Central Bank, as investors weigh the possibility of additional tightening against the need to preserve growth. Europe also offers exposure to a wide range of internationally active companies whose fortunes are not determined solely by domestic economic conditions. For long-term investors, the combination of varied industries, differing national economic cycles and valuations across the region provides opportunities for diversification, even as financing costs and fiscal uncertainty require careful attention.

Global Markets

Across global markets, the central question is whether steady economic growth and improving corporate profits can absorb a higher cost of capital. Bond markets are setting much of the tone: an orderly adjustment in yields may be manageable, but a sudden repricing could spill into equities, credit and currencies. The US-China relationship remains another important variable, with any extension of the trade truce potentially helping business confidence while unresolved structural tensions continue to affect supply chains and investment decisions. China's PMI data will offer an early indication of how domestic demand and export activity are developing. Meanwhile, differing inflation and interest-rate paths across major economies are creating opportunities as well as risks. This reinforces the value of a genuinely global investment approach, with exposure spread across regions, asset classes and companies rather than concentrated in one market or theme.