Equity markets continued to look a little soft yesterday against a backdrop of rising bond yields and rising inflation expectations, as both European and US markets finished the day lower. US markets closed at their lowest levels in over a month.

While both German and US yields have also been on the rise it is UK gilt yields that have come under particular scrutiny due to the speed of their rise from the lows seen at the beginning of this month, which some have put down to reduced confidence in the UK economy, against a back drop of significant disagreements between senior members of the government, about the right approach to “Brexit” negotiations.

While there may be an element of that with respect to the selloff in UK gilt prices it is unlikely to be the primary reason for the fall in prices and the rise in yields. The real reason for the sharp rebound in yields is more likely as a result of sharply rising inflation expectations as a result of the decline seen in the pound since June.

UK inflation expectations had already been rising in the lead-up to the Bank of England decision to cut rates in August and the resultant drop in yields from 1.4% just prior to the Brexit vote to lows of 0.501% seen in the middle of August, after the Bank of England’s aggressive easing program, marked a significant overshoot to the downside, which now appears to be being corrected

Last week’s spat between Tesco and Unilever is likely to be a foretaste of what to expect in the coming months as retailers and suppliers look to try and maintain their margins in an extremely competitive sector. While in this instance the behaviour of Unilever in seeking to hike its prices was highly questionable given that most of the products in question are made here, it nonetheless gives us a flavour of what to expect in the coming months as higher import costs start to trickle down into the supply chain.

It is this rise in inflation expectations that prompted a recent warning from MPC member Kristin Forbes to warn of the risks of inflation sharply overshooting its 2% target in the next two years, which probably helps explain her decision to vote against the decision to expand the QE program, in August.

Given this rise in inflation expectations it would therefore make no sense for anyone to hold UK gilts at levels that yield less than 1%, and despite peaking at 1.2% yesterday, UK gilt yields closed at 1.123%, still below their pre Brexit levels of 1.4%

Today’s inflation numbers for September are expected to reinforce the recent rise in inflation expectations when CPI is expected to show a rise from 0.6% to 0.9%, while RPI is expected to rise from 1.8% to 2%.

It is also worth keeping an eye on input prices, they rose 7.6% in August, and they are likely to stay at these levels and potentially head higher in the coming months, which is likely to pose a problem for retailers looking to maintain their margins.

Later in the day US CPI for September is also expected to point a sharp rise, from 1.1% in August to 1.5%, reinforcing expectations that the Fed will move to push rates higher in December. US 10 year yields have also drifted higher in recent days hitting their highest levels since 2nd June at 1.8119%, though they did slip back late on after some disappointing manufacturing data, prompted some profit taking.

EURUSD – the euro continues to hold above the 1.0950 area but needs to recover back through 1.1100 to stabilise, or risk a break below 1.0950 towards the 1.0800 area. Upside resistance remains at the 1.1300 level.

GBPUSD – the pound continues to derive support just above the 1.2100 level but we need to see a move through 1.2300 to argue for a move towards the 1.2500 level. A break below the 1.2000 area has the potential to open up the previous flash crash lows at 1.1950, and possibly lower.

EURGBP – currently trading between the 0.9080 level and support at 0.8960 after last week’s dart up to 0.9300. A move back through 0.8960 could well see a move back towards the 0.8780 level with a break arguing for a move back towards the 0.8720 level.

USDJPY – continues to find progress beyond the 104.30 area difficult to sustain for now which raises the risk of a move back towards the 103.20 area. A sustained move through 104.50 could well see a move towards 105.70.

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