Good morning. A rout in global bond markets is intensifying and the dollar is climbing as an outbreak in hostilities between the US and Iran revives inflation risks, raises the likelihood of interest rate hikes in the months ahead, and makes safe havens more appealing.
Energy prices are ratcheting higher after two supertankers were reportedly struck by anti-ship missiles while passing through the Strait of Hormuz overnight. With the threat of a prolonged disruption once again growing more acute, Brent is trading near $92 a barrel, up 4% over the past week, while West Texas Intermediate stands at $88, up roughly 6%. European natural gas prices have risen almost 6% in two days as record-low inventories set the stage for a surge in buying ahead of winter. The currencies of major net energy importers—the euro, pound, and yen—are back on the defensive.
Partly fuelled by a rise in inflation expectations, long-term borrowing costs are climbing across the advanced economies. Japan’s benchmark ten-year yield this morning hit the symbolic 3% mark for the first time since 1996—but the move is no outlier, with German ten-years marking their highest levels since 2011, while British and French rates push past thresholds breached in 2008. Long-term Treasury yields are experiencing their third spike in the last five years, with the prior two accompanying the Federal Reserve’s aggressive tightening in late 2023 and the run-up to Donald Trump’s inauguration last year.
Behind the tactical rise in rates, a complex mix of forces is pushing yields higher. They are hard to disentangle precisely*, but we think three are at work. Demand is growing more fragile: after a buying spree that ran for decades, emerging-market central banks have slowed their reserve accumulation, their rich-world counterparts have wound down their unconventional easing, geopolitical shifts are sapping the capacity of oil exporters to recycle savings into advanced-economy debt, and Japan, stirring from its long slumber, is providing less marginal demand for bonds. Price-sensitive private investors, in short, have become the marginal buyers in global bond markets. Competition for capital is intensifying: debt burdens are soaring as rich-world governments, America foremost among them, run vast primary deficits; nations are rearming and rebuilding infrastructure; firms are investing in factories and commodity production; and the hyperscalers are borrowing heavily to fund the artificial-intelligence boom. And expectations are shifting: political polarisation across the big democracies is stoking worries about sovereign credit risk, inflation is turning more volatile as the global economy fragments and trade barriers rise, and hopes of an AI-driven surge in growth and productivity are reshaping estimates of long-term capital returns.
To some degree, this simply means rates are resetting to the “normal” levels that prevailed in the early aughts. But markets are hardly in the clear. In the historical record, sharp rises in long-term yields have often preceded dislocations in the financial system, as higher borrowing costs strain business models, squeeze the leveraged and erode asset values—exposing fragilities built up previously**. Whether today’s correction proves similarly disruptive will depend, as ever, on where the hidden weaknesses are buried; and those, by definition, tend to surface only after the fact.
Against this backdrop, measures of expected volatility look too low. Implied volatility in currency markets is tracking lower, while the VIX index—which tracks anticipated moves in share prices and is often called Wall Street’s “fear gauge”—holds near the 15 threshold, well below seasonal averages, despite the fact that markets tend to hit turbulence during the transition from summer to autumn***.
Traders are bracing for a dovish message from the Bank of Canada in tomorrow’s rate decision. This is not necessarily a reflection of negative fundamentals. The Canadian economy has shown clear signs of gathering momentum in recent months, with exports, consumer spending, business investment, employment, and overall growth consistently topping both market expectations and the forecasts set out in the Bank’s July monetary policy report.
But since mid-August’s breakdown in tariff talks, policy uncertainty has soared once again, threatening to weaken trade volumes, destroy jobs, and paralyse activity across the economy. We—and most market participants—suspect officials will have little choice but to temper previous displays of inflation hawkishness while expressing wariness over the economic trajectory ahead.
Does that mean the Canadian dollar will fall? Not necessarily. If most participants expect a dovish message, that dovish message has likely been priced into the exchange rate. What happens in currency markets around the decision will hinge on small, unexpected nuances in the language—nuances that could very well translate into some loonie strength. The currency remains astonishingly stable—its trading range this year has been far narrower than during many of the upheavals over the last quarter-century. And hedgers are still paying more for downside protection on the US dollar index than on the Canadian dollar, a sign that many expect talks between Ottawa and Washington to resume before long, setting the stage for some appreciation north of the border.
*Nobel prizes are given out for less.
**As Warren Buffett put it: “Only when the tide goes out do you discover who’s been swimming naked” .
***Mark Twain said “October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.”