Market Brief: Bond selloff worsens, pushing currency markets out of trading ranges

Government borrowing costs are pushing to multi-decade highs around the world this morning as a brutal selloff in bond markets intensifies. Ten-year Treasury yields are up 0.04 percentage points to 5.34%, their highest levels since 2002, Japanese bonds are going for the most since the mid-nineties, and rates in most other advanced economies are edging past thresholds last touched ahead of the global financial crisis in 2008. Global oil benchmarks are climbing once again, and the dollar is outperforming all its major peers as rate differentials widen, pushing currency markets into deeply-oversold technical territory.

We don’t have a good handle on what is driving the turbulence.

Observers have offered a number of explanations. Some see foreign factors playing a role, pointing to yesterday’s higher-than-expected inflation data in the euro area or Japan's policy normalisation, which they argue is driving a reversal in the yen-funded carry trade. Others think turbulence in oil markets is at fault. And still others are pinning the blame on a raft of US data releases, which showed private payrolls growing by more than expected, consumer savings rates climbing, and the economy firing on all cylinders in the second quarter.

None of these explanations quite fits the facts. The episode gathered momentum well after the European data was released, there was no jump in the yen that would signal a carry trade unwind, and oil prices retreated as long-term rates climbed. The Federal Reserve’s preferred inflation measure came in softer than expected in August and the prior two months’ readings were revised down, offsetting evidence of strong consumer balance sheets and the second-quarter gross domestic product revisions, while lowering market-implied odds on an October Federal Reserve rate hike.

What is clear, however, is that structural shifts in Treasury markets are exacerbating the selloff. As we and many others have long warned, the marginal buyer in government bond markets has become much more price sensitive in recent years, with the US household sector soaking up the vast bulk of new issuance, supplanting the Fed, domestic pension funds and insurers, and the foreign official sector. With the US economy performing well, inflation fears becoming more entrenched, hyperscalers and governments borrowing record volumes, and fiscal worries growing more acute, many investors are demanding a higher premium for holding Treasuries—and it isn’t clear how high yields need to go before they capitulate.

Against this backdrop, the euro is trading near a 17-month low as traders grapple with wide rate differentials against the dollar, worsening commodity terms of trade, and growing political uncertainty. The gap between US and German two-year yields is near 180 basis points, the widest since early last year. As a large net importer carrying unusually low natural gas inventories into the colder months, the bloc is on the wrong side of recent developments in the Middle East, where crude exports have ramped up but liquefied natural gas shipments have not. And with hard-right parties advancing in France and Germany, and France facing another budget battle, intra-euro yield spreads are blowing out, putting further strain on the common currency. In options markets, risk reversals—which measure the cost of insuring against a fall in the euro—have turned sharply negative as participants rush to secure protection. This may prove overwrought, especially if the energy price cycle turns, but for now, it's only prudent to assume that risks are skewed to the downside.

Tomorrow’s non-farm payrolls report could take some of the impetus out of the move in yields by depicting a slowing labour market. A job-creation rate above the 100,000 mark could push the dollar higher, but we see risks as tilted to the downside given that last month's blockbuster 162,000 gain was driven in large part by a change in seasonal adjustment factors—and we expect softness to emerge in the leisure and hospitality sector in particular as the autumn months get underway.

*Then again, given that markets are behaving in baffling ways, it may be premature to assume anything about how investors will react. In this environment, all bets are off.

Economic Calendar