Global Bond Sell-Off Deepens on Strong US Data and Rate

A global bond sell-off deepened after surprisingly strong US business data heightened fears that the economy is overheating, forcing investors to price in more aggressive Federal Reserve interest rate hikes. Yields on US, UK, and Japanese government bonds surged to multi-year highs, pulling down share prices.

Yesterday's trigger was a flash Purchasing Managers' Index survey showing US business activity expanding at its fastest pace in over five years. New orders grew at the fastest rate since April 2022, while manufacturing hiring was the strongest since February 2021. The data pointed to resilient consumer spending and massive AI investment, though it also showed elevated input costs and stretched supplier delivery times.

Chris Weston, head of research at brokerage Pepperstone, said the US economy is showing signs of modest overheating with unemployment at 4.1% and growth running above trend. "The Federal Reserve will therefore be firmly on notice," Weston said. He added that if upcoming inflation readings remain high, policymakers may conclude that aggregate demand needs to be lowered through higher interest rates.

Market Reaction and Yield Surge

The bond market reaction was swift and severe. The sell-off pushed the yield on five-year US Treasuries above 5% for the first time since 2007. The yield on 10-year US Treasuries also surged over 5%, marking its biggest one-day jump since the market turmoil around former President Donald Trump's 'Liberation Day' tariff announcement approximately 18 months ago.

Investors were further alarmed by a surprisingly weak auction of US five-year bonds, which attracted low demand. According to Deutsche Bank market strategist Jim Reid, futures markets are now pricing a 71% chance of a Fed rate hike at the next meeting in October. The CME Fedwatch tool indicates a 55% probability that US rates will be half a percentage point higher by the end of December.

Global Contagion and Central Bank Watch

The sell-off in US debt, considered the global risk-free benchmark, rattled bond markets worldwide. In Japan, government bond yields climbed to multi-decade highs. Key Japanese bond yields rose as follows:

UK government debt was also caught in the sell-off. The yield on 10-year UK gilts jumped by 10 basis points, moving toward its highest level since the 2007 financial crisis. This rise threatens to shrink the UK government's fiscal headroom by increasing debt servicing costs.

Fiscal and Economic Ripples

Rising gilt yields complicate the UK government's fiscal position. Rachel Reeves left her successor, John Healey, a buffer of over £23 billion to remain within fiscal rules requiring day-to-day spending to be covered by tax receipts and for debt to fall as a share of the economy. With government spending running above forecast, economists predict this headroom has already shrunk.

Government figures are preparing to argue that maintaining March's large buffer is unnecessary given sharply higher borrowing and energy costs. One person involved in discussions suggested headroom of £15 billion would be sufficient, while another suggested closer to £20 billion. A senior government figure said there was "no magic figure" to demonstrate market credibility, arguing that Britain's plan for rapid deficit reduction was potentially more important.

In contrast to the strong US picture, the European Bank for Reconstruction and Development warned of slowing growth across emerging markets. The EBRD expects growth of just 2.5% this year across the 41 economies it covers, a downgrade of 0.6 percentage points from its June forecast. It cited the effects of war in Iraq, Lebanon, and Ukraine, combined with high energy prices, rising borrowing costs, droughts in Europe, and the ongoing closure of the Strait of Hormuz.

Financial markets await key events including the Swiss National Bank's interest rate decision, US jobless claims data, and a speech from the Bank of England's Clare Lombardelli on macroeconomic policy.