My mind is drawn back to the dot.com boom. The US was running a fiscal surplus and attracting the world’s capital. China had not yet joined the World Trade Organisation. Europe was still dealing with the aftermath of the fall of the Berlin Wall. As the US economy outgrew the world, it raised the cost of financing for everyone, because it had become the natural home for capital. The flight of capital in search of higher returns is unstoppable, particularly in the reserve currency.
As things stand, the US economy is set to outgrow most of its developed peers again. As it draws in capital, it starves other markets of financing. The 10-year Treasury now offers close to 4.8%, its highest level since late 2023. This sets the bar for every capital allocation decision that asset allocators face as they position portfolios.
Credit markets are seeing their own shifts, emanating from two separate sources:
The first is a common thread in markets and is driven by the capex bulge we are seeing in the US. This is being fed by tax incentives in the Big Beautiful Bill, the AI buildout, and a degree of onshoring. Manufacturing and capex, after years of neglect, have become the principal drivers of US growth. Economic growth is driving revenues and profits, allowing limited actual defaults despite the cost of debt being higher than average.
The second key driver is the influence of private markets. This sector, mainly in the US, has become a powerful source of funding. It has drawn consternation due to some high-profile defaults last year. It provides a distinct funding advantage to private and less-than-investment-grade issuers but comes with its own complexities and concerns.
The flexibility and scale of US debt markets provide a natural venue for issuers. But the scale of corporate and government issuance, given the AI and broader capex boom, is increasing competition for capital and putting upward pressure on yields. This competition for capital, amid an elevated inflation backdrop, creates a source of risk that the Federal Reserve (Fed) needs to navigate.
See also: It pays to pay attention… to a broader set of data
The inflation story is nuanced. The good news is that services inflation is abating. Consumer spending has moderated, supporting a case for continued disinflation outside energy. July core CPI was 2.5% year-on-year, which supports the disinflation narrative on its own.
The Fed’s 2% inflation target is measured by headline PCE, while core PCE has been stuck near 3.3% for two straight readings. That is above target, and real consumer spending has flatlined alongside it. Sticky inflation next to stalling growth looks closer to stagflation than disinflation, whatever the core print might suggest. Like the equity market, the Fed is aware of rising capex, full employment, and rising money supply. Bond investors face skewed outcomes if the Fed fails to act.
This brings us to the September FOMC meeting. Markets are pricing in a greater than 60% probability of a 25-basis point hike, reinforced by Kevin Warsh’s hawkish remarks at Jackson Hole in late August.
My concern is whether the rhetoric translates into a vote for a hike. Central banks often talk tough without following through, particularly with a run of soft labour data sitting alongside sticky inflation and the chair has been in the role for barely four months.
A hold accompanied by hawkish communication would not be unprecedented. If the Fed holds, markets will have to decide how credible the hawkish talk ever was, and long-end yields may simply keep drifting higher because talk without action changes nothing. Some action is warranted before year-end. Treasury efforts to rein in yields through changes to the issuance mix could instead add to the pressure.
This backdrop brings us to the UK gilt market. We have known for a while that UK government debt offers a poisoned chalice to domestic investors. On the one hand, it is risk-free return in sterling. On the other, it carries eight years of duration, which makes any move in yields highly punishing.
That risk has now materialised. The 10-year gilt yield is 5.26%, its highest level since June 2008, an 18-year high. Yields are up roughly 30 basis points over the past month and 80 basis points since the start of the year.
See also: Licence to yield: Why bonds deserve a second look
While the UK government has not helped investor sentiment, the bigger story has its origins in the US and the capex-driven boom in debt issuance. But this is not purely an imported problem. The Bank of England (BoE) has its own inflation issues. Markets are pricing in a nearly 60% probability of a rate hike in November. The BoE’s hand is being forced domestically, independent of what the Fed does in September. Central bankers need to demonstrate resolve into a politically charged backdrop. Bond markets, as always, will be willing to call out the lack of action.
It is all getting quite interesting in the macro world. As everyone awaits the Fed pivot, central banks elsewhere will need to act. The Bank of Japan, the BoE and the European Central Bank (ECB) must demonstrate a degree of independence, knowing full well that US economic acceleration will continue to drive the real cost of money.
Against this backdrop we continue to favour shorter-duration government debt and select exposure to credit risk through investment-grade and high-yield debt. While we hope for greater clarity on monetary policy in September, we can see things remaining vague until the December meeting. A strong year for equity markets has left many investors considering how to protect gains in a higher-for-longer world.
Fahad Hassan is CIO at Albemarle Street Partners, which is now part of WisdomTree
