Market sentiment turned into risk-off mode this week. Equity markets declined, credit spreads widened and the VIX volatility index jumped on the back of hawkish comments from the Federal Reserve, a rising inflation outlook, combined with uncertainty whether an increase in the US debt ceiling could be passed in Congress. The broad based risk-off mood and spike in market volatility also weighed heavily on risk-, commodity- and USD-rate sensitive currencies and EUR/USD fell below the 1.16 level. However, rather than seeing the traditional flight-to-quality in a risk-off environment, global yields continued to rise. 10Y US treasuries have broken through 1.5% with the yield curve steeping, while 10Y German government bond yields tested the -20bp-level. While rising yields in itself, from current levels, are not necessarily bad for equities, the speed of the change combined with the turning macro momentum, central banks slowly shifting gear, and jitters in the Chinese financial markets currently create a toxic cocktail for markets.
The mounting energy crisis in Europe also contributed to souring risk sentiment. While market focus in recent weeks primarily centred on rising gas and electricity prices, focus this week shifted to the oil market. Brent crude briefly rose above USD 80/bbl, the highest level in almost three years, and inflation expectations also moved higher after German inflation surged to 4.1%, the highest since 1993. Despite the rising market concerns about ‘stagflation’, Fed chair Powell, ECB President Lagarde, Bank of Japan Governor Kuroda and Bank of England Governor Bailey all basically repeated that the current high inflation rates will be temporary at a virtual panel debate. That said, global central banks have started the (cautious) process towards a post-corona policy normalisation, with Fed and Bank of England taking the lead. Markets increasingly believe that ECB will eventually follow suit with a first rate hike now priced in for Q2 2023.
Germany’s election left the country in unchartered territory, with a possible change in government. As the largest party in the Bundestag, the Social Democrats’ (SPD) candidate Olaf Scholz has the best chances to succeed Angela Merkel, but his fortunes will depend on the coalition negotiations. ‘Traffic light’ (60% probability) and ‘Jamaica’ (40% probability) coalitions are the most likely in our view, but difficult and lengthy coalition negotiations could drag well into 2022 (read more in German Politics Monitor – Let the game of thrones begin!, 27 September). The market reaction on the election result was muted, also because a pure left-wing coalition of the SPD, Greens and the Left, which held the biggest potential for a fiscal regime shift, failed to gain a majority.
Next week’s key release will be the September US jobs report on Friday, which will be important with respect to whether the Fed already starts tapering in November. After the weak August report, focus will be on whether employment growth accelerated after higher benefits expired or whether more deeper running issues (i.e. supply problems or slowing demand?) are holding back jobs growth. While markets have quickly moved on to other issues, we will also keep an eye on China’s ongoing property crisis (see Research China – ‘No ‘Lehman moment’ but financial stress is not over, 29 September 2021). Finally, Reserve Bank of New Zealand will meet early Wednesday morning, with markets pricing in a 80% probability of a 25% rate hike, after corona restrictions have been loosened.
