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Bond markets vulnerable amid rising inflation concerns

Nothing in last week’s US economic data appears to have altered expectations that the Federal Reserve will look to raise interest rates by the end of this year, probably at its meeting in December. The currency markets already appear to be pricing in just such a prospect with the US dollar index closing at its highest level since early March.

Last weeks Fed minutes didn’t really alter that calculus either, in fact they only served to reinforce it, given the fact that recent economic data shows no signs of any significant weakness. Friday’s retail sales numbers for September came in slightly ahead of expectations, more than reversing the small decline seen in August, while weekly jobless claims continue to come down.

Despite a positive end to the week for US stock markets and some decent earnings reports for US banks, US markets still closed lower for the second week in succession.

While US markets are starting to show all the hallmarks of looking a little soft, the FTSE100 did manage to put in a new all-time high last week, however even here there is some evidence that it could struggle to sustain these levels, given the sharp pullback seen in the wake of that high.

It was a slightly better performance for markets in Europe also aided by a rebound in banking stocks, with Italian banks jumping sharply on reports, subsequently confirmed over the weekend that Banco Popolare and Banca Popolare di Milano had agreed to merge.

The Italian banking sector has long been the soft underbelly of Europe’s weak banking sector and it is hoped that this merger will help shore up confidence in Italy’s banks. That remains to be seen given recent experience in Spain, when smaller banks there were also forced to merge. All that succeeded in doing was turning a number of small problems into a giant great big one, and a resultant huge bailout package.

Investors will be hoping that this deal is different, however until the problems of the huge number of non-performing loans are dealt with the fear is that this deal could well be the equivalent of two drunks propping each other up at the bar.

What is also a little worrying is the sharp rise in bond yields seen throughout last week, not only in the UK, but also in Germany and the US. Much has been made of the fact that UK yields have more than doubled since August, but they are still well below their pre-Brexit levels. Furthermore they had been sharply pushed lower by the Bank of England surprise move to go all-in on its various easing measures at the beginning of August, which probably caused an overshoot on the downside.

It would appear that rising inflation expectations are behind some of these moves with the US 10 year yield closing at its highest level since 2nd June, while German 10 year yields posted their highest weekly close since mid-June.

This move in bond markets could well have further to run, particularly since we have inflation data out this week from Europe, the UK and the US, as well as the latest ECB rate meeting.

Later this morning we have the final EU CPI number for September which is expected to come in at 0.4%, with core prices at 0.8%.

With the ECB meeting later this week it would be highly unusual if ECB President Mario Draghi were to say anything about recent chatter with respect to discussions about a tapering program, however it is clear that there is some debate on the governing council about the toxic effects negative rates are having on the banking system. Bundesbank President Jens Weidmann is also due to speak at around the same time.

Tomorrow’s inflation data from both the UK and US will also be closely monitored for evidence of rising inflationary pressure, particularly in the UK given the sharp falls in sterling and last week’s spat between Tesco and Unilever about price increases on various popular grocery brand products.

It will also be a big week for the latest Chinese economic data covering Q3 GDP, after last week’s disappointing trade numbers and hotter than expected inflation numbers.

EURUSD – has managed to remain above the 1.0950 area for now 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 is currently finding 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 last week. 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 – the US dollar continues to look well supported but has, as yet been unable to sustain a move through the 104.30 area, despite briefly trading up to 104.63 before slipping back. A move through here could well see a move towards 105.70. Support currently sits back at the 103.20 area. A break through here could well see a fall back towards the 102.20 area.

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