US stocks fall and Treasuries rise: What is worrying markets?

  • The yield on the 10-year US Treasury fell below 5%, while the stock market decline was driven primarily by a sell-off in AI stocks. BofA concludes that market concerns have extended from technology companies’ financing needs to whether enormous AI investments can generate revenue and profits.
  • The key to the inference is the direction of prices: if the main concern were increased bond supply, long-term Treasury yields should face upward pressure. Falling yields alongside falling stocks are more consistent with weakening expectations for growth and investment returns. BofA also regards a loss of momentum in the AI trade as one of the main risks to the US economic outlook.

Why has rising risk aversion not eliminated inflation pressure?

  • The Middle East conflict has kept crude oil above 110 dollars a barrel, while attacks on refining capacity have intensified pressure on refined products such as diesel. BofA believes energy is unlikely to provide significant inflation relief next year at the very least, and sustained disinflation will have to rely on other consumer spending categories.
  • Europe also faces additional fiscal pressure: France’s 10-year government bond yield rose to its highest since 2002 and exceeded the equivalent US yield for the first time since the European debt crisis. Social unrest and the approaching 2027 presidential election make fiscal consolidation more difficult; the rise in French yields has further increased market risk aversion.

Why is there a case for a Fed hike in October, yet it may be difficult to deliver?

  • BofA maintains its call for a 25-basis-point hike in October: inflation in September exceeded expectations by a wide margin and across a broad range of categories, offsetting the improvement from earlier downward data revisions. Meanwhile, the term premium on 10-year US Treasuries has fallen by more than 25 basis points, weakening the role of long-term rates in tightening financial conditions on the central bank’s behalf.
  • But the bank is considerably more confident that the Fed should raise rates than that it actually will. Markets price in only about a 10% probability of a hike in October, while weaker risk assets raise the shock cost of a surprise hike.
  • Both decisions carry communication costs: a hike could raise concerns about excessive tightening, while a pause could damage anti-inflation credibility. If the Fed pauses in October, BofA still expects one hike each in December 2026 and March 2027; only significant damage to the economy would undermine the case for further hikes.

Why are the ECB and Bank of England moving at different speeds?

  • The ECB has more room to wait: inflation and activity data are slightly weaker, while higher long-term rates have already restrained the economy. BofA expects rates to remain unchanged next week with slightly dovish communication, followed by one final hike in December. If the economy deteriorates more than expected, the ECB could also pause in December; if energy prices continue to rise more than expected, there is a risk of another hike in March next year.
  • Pressure to act is more immediate in the UK. Year-on-year CPI inflation in September rose from 3.1% to 3.5%, 44 basis points above the Bank of England’s forecast; core services inflation excluding airfares, package holidays, education and accommodation also rose from 3.9% to 4.1%. Unemployment fell from 4.9% to 4.7%, further strengthening BofA’s call for a hike in November.
  • However, UK wage growth has yet to accelerate noticeably, the pass-through of the energy shock to core inflation remains relatively limited, and food inflation is also moderate. BofA therefore believes the nearly four hikes priced by markets are excessive and expects two hikes, in November and February next year, to bring the policy rate to 4.25%.