Two drivers of financial markets: bond yields and economic data

This week it’s all about key economic data releases, alongside what the bond market does next. The poorly received auction of 30-year US Treasuries late on Thursday sent bond yields in the US higher at the end of last week, which gave the dollar a new lease of life. Concerns about term premium re-surfaced and as the Federal Reserve seems to be firmly on pause, the focus is now on the non-interest rate movers of bond yields, and this includes supply and demand. Looking at the week ahead, the market needs to be focussed on multiple market drivers including some important economic data, the tail end of earnings releases, particularly for the UK, political strife in Washington, and more Treasury auctions.

Treasury auctions back in the spotlight

Looking at the Treasury auctions first, there is less supply on offer during this coming week, with some short-term bill auctions at the start of the week, followed by a 20-year bond auction on Thursday and a 10-year TIPS auction, which are Treasury Inflation Protected Securities. These will be watched closely, and the TIPS auction will be particularly interesting after Tuesday’s inflation data for October. Ahead of the October CPI data, the University of Michigan consumer sentiment data for November was interesting, firstly consumer sentiment notably dipped to 60.4 from 63.8 in October, added to this, the 5-year consumer inflation expectations index also rose to 3.2% from 3%. This is the highest level for more than 5 years. The University of Michigan said that the slip in consumer confidence was down to geopolitical tensions and higher interest rates starting to bite, which is particularly impacting consumer sentiment towards house, car, and durables purchases. Year ahead inflation expectations also rose to 4.4%, the highest level since April. It is supportive of the more hawkish tone taken by Fed chair Powell in his speech last week, as it is significantly above the 2.3% - 3% range seen in the 2-years before the pandemic. The Fed’s fight against inflation is not over. Linking this back to the Treasury auction, with consumer inflation expectations rising sharply, this could lead to investors demanding higher yields at this week’s TIPS auction.

The FX views

From an FX perspective, we expect the dollar to chase any spike higher in Treasury yields this week. The dollar index rose 0.7% last week to a high just below 106.00. Interestingly, there was decent selling pressure at this key level. Likewise, key resistance was reinforced in USD/JPY at 151.50, however, this pair was higher by 1% last week, which suggests that as long as the BOJ maintains yield curve control and the yield differential is in the dollar’s favour, long-term USD/JPY bears looking for a sharp fall in this pair below 150.00 could keep getting burned. In the short to medium term, we continue to think that US yield curve dynamics will dominate the G10 FX space and that the rebound in US Treasury yields, the 10-year yield rose 16 basis points at the end of last week, will provide a floor in the dollar for now. However, to see a serious leg higher in the dollar we will need to see a sustained rebound in the economic data. If we continue to see poor Treasury auctions this could spook investors, with the dollar falling at the same time as Treasury yields are rising. While we think that this is an unlikely situation, if it were to happen it could signal serious stress in the USD-based financial system.

US Economic data watch

While we continue to think that Treasury auctions are the new economic data as we move into the final weeks of the year, the economic data still matters. This week’s US CPI report on Tuesday and the US retail sales for October on Wednesday are worth watching closely. The market is expecting US CPI to moderate for October, with the headline rate expected to rise by 0.1% on the month, compared with a 0.4% increase in September. The annualised core CPI rate is expected to remain steady at 4.1% YoY. Unless we see a sharp decline in US CPI, which we think is unlikely, then we are unlikely to see US bond yields fall too sharply. Elsewhere, the pound will also be in focus as we get employment data and CPI from the UK this week. After the 0% GDP growth rate in the UK for Q3, expectations remain muted for the performance of the UK economy for the last three months of the year. Labour market data in the UK is hard to predict due to problems with data gathering at the ONS, however, watch out for any downside surprises or downward revisions to prior data as that could spread fear about the UK economy. Wage growth is expected to moderate to 7.7% 3-month YoY rate for September, down from 7.8% the month prior. As we have mentioned, average wages data are basically useless, since high earners who get a pay rise can distort the data. Obviously, any major deviation from the expected rate could see a big FX market reaction.

UK economic data watch

UK CPI is also released on Wednesday, and the market is expecting a large decline in the inflation rate. The headline rate for October is expected to fall to 4.8% from 6.7% in September, due to base effects from last year. This would pull the UK back to the G20 average of inflation, and could generate good will towards UK stock prices, if inflation does indeed fall this far. The core rate of price growth is also expected to decline 5.8% from 6.1% in September, and the retail price growth rate is expected to fall to 6.4% from 8.9% in September. This large move lower in the UK’s inflation profile could weigh on GBP, especially if the dollar is buoyed by stronger US Treasury yields this week. GBP/USD was one of the weakest of the dollar crosses last week, falling 1.2%. For now, GBP/USD is trading in a short-term range, between $1.21 and $1.24. A dip below the $1.21 level could trigger a move back below $1.20 as we move into the end of the year.

Politics, stocks, and earnings

To finish off, it is worth watching out for some earnings releases this week. In the UK, British Land, Vodafone, and Premier Foods are the highlight. Politics are also worth watching, as the extension to the US debt ceiling will expire on Friday. With the geopolitical risk still high, a US government shutdown would be terrible for risk sentiment, in our view, and for US Treasury auctions, so we expect a further extension to the debt ceiling early next week.

Is the Santa Rally finally here?

Stocks rallied last week, and the S&P 500 was up more than 1%. Over the last two weeks the S&P 500 is higher by 7%, the best 2-week stretch of the year. People are trying to position for a year-end rally, and bearish bets on the S&P 500 and the Nasdaq are getting slashed. Stocks seemed to have ignored the volatility in the bond market at the end of last week and are instead rushing into equities now that it looks like a US economic recession is off the cards. In fairness, the doomsday scenario for the US and the global economy has not come to pass, and this could trigger a move away from the safety of cash and into higher yielding equities, especially if we have reached peak interest rates. The ‘magnificent 7’ tech stars in the US continue to drive markets, and if we are at peak rates then these tech giants could continue to outperform and drag the broader S&P 500 higher for the rest of the year. If you’re an optimist, then the Santa Rally may have arrived!