Inflation rises, but bonds tell a different story

Financial markets ended last week with an unusual contradiction. US inflation was hotter than expected, yet Treasury yields fell sharply as investors abandoned some of the technology shares that have led Wall Street's advance.

September's consumer price index rose 0.6% on the month, lifting annual inflation to 3.7% from 3.4% in August. Core inflation, which excludes food and energy, increased 0.3% and reached 2.6% annually. Gasoline accounted for more than half of the headline monthly rise, although higher shelter costs and several other categories suggest underlying price pressures have not disappeared.

The producer price figures offered little comfort. Final-demand prices climbed 1.3% in September, their largest monthly increase since March 2022, taking annual producer inflation to 6.3%. Even excluding food, energy and trade services, prices rose 0.5% during the month.

For businesses, this presents an uncomfortable choice. Higher input costs must either be absorbed through lower margins or passed on to customers who are already feeling the strain.

Consumer spending has nevertheless held up. Retail sales increased 0.8% in September, comfortably exceeding expectations for a 0.3% rise. But the headline flattered the underlying picture. Higher petrol prices inflated nominal spending, while the more closely watched control-group measure rose just 0.1%.

The Federal Reserve therefore faces a difficult balancing act. Policymakers cannot afford to dismiss persistent inflation, but neither will they want to tighten aggressively in response to a potentially temporary energy shock. Markets continue to favour a pause in October, with another increase more likely in December.

AI investors are asking harder questions

The bigger market story, however, has been the sudden loss of confidence in technology shares.

The NAS100 fell 5.48% last week, its worst performance since June. The SPX500 lost 1.97%, while the US2000 declined 3.06%. The US30 managed a 0.55% gain, highlighting the rotation away from growth-oriented companies. Semiconductor stocks were hit particularly hard, with the Philadelphia Semiconductor Index falling approximately 11.4%.

What makes the correction interesting is that the underlying demand picture remains relatively strong.

ASML and Taiwan Semiconductor reported encouraging results, reinforcing expectations that investment in advanced computing infrastructure remains substantial. Yet their operational strength offered little protection from the broader sector sell-off.

That tells us something important about investor sentiment. The market is no longer satisfied with evidence that demand for artificial intelligence exists. It wants greater confidence that the enormous sums being committed to data centres, computing equipment and supporting infrastructure will generate acceptable returns.

CoreWeave illustrates the concern. Its shares lost roughly a quarter of their value over five trading sessions as investors scrutinised the financing requirements of capital-intensive cloud infrastructure.

The distinction matters. A business can enjoy strong demand and still struggle to deliver attractive shareholder returns if financing costs, competition or capital expenditure become excessive.

Attention now turns to the coming earnings reports, particularly Meta. Investors will be listening closely to management's spending plans and, more importantly, the evidence that such expenditure can translate into sustainable cash generation.

Bonds regain some defensive appeal

Against this backdrop, the Treasury market has behaved rather differently from what the inflation data alone might suggest.

The US ten-year yield finished last week near 5.08%, falling approximately 16 basis points despite the stronger price reports. Investors appeared more concerned about the outlook for risk assets than the immediate possibility of further monetary tightening.

There is an important qualification, though. A ten-year Treasury yield around 5% still represents a substantial cost of capital. It remains a headwind for mortgages, corporate refinancing and equity valuations.

In Europe, monetary policy is similarly complicated by inflation and financing pressures.

European Central Bank President Christine Lagarde has acknowledged that rising government-bond yields are tightening financial conditions, potentially restraining both economic activity and inflation. Another ECB rate increase remains a meaningful prospect, although policymakers must weigh that against weaker growth.

In the United Kingdom, expectations have shifted more decisively towards tightening. A Reuters survey found that 54 of 63 economists expect the Bank of England to increase Bank Rate from 3.75% to 4.0% in November. Inflation remains above target, while the approaching Budget adds another source of uncertainty for government bonds.

Japan faces a different challenge. Bank of Japan Governor Kazuo Ueda believes underlying inflation is approaching the central bank's 2% objective, supporting the case for further gradual normalisation. Nevertheless, officials appear inclined to assess the effects of September's increase before moving again.

China delivers growth, but the imbalance remains

China provided a more encouraging economic surprise.

Third-quarter GDP expanded 4.5% from a year earlier, beating expectations for 4.4% and improving on the previous quarter's 4.3% growth. Quarterly output increased 1.2%, while September industrial production rose 5.5%.

Retail sales also improved, increasing 1.1% annually compared with just 0.4% previously.

On the surface, these figures suggest that the economy has regained some momentum. The problem is where that growth is coming from.

Exports, advanced manufacturing and technology-related activity continue to do much of the heavy lifting. Household demand remains relatively subdued, while property development investment contracted 20.6% during the first nine months of the year.

Beijing can take encouragement from the stronger GDP number, but the economy has yet to establish a convincing consumer-led recovery. For investors hoping for a major stimulus programme, better headline growth could also reduce the immediate pressure on policymakers to act.

Oil keeps the inflation threat alive

Energy prices remain a critical link between geopolitical developments and monetary policy.

Oil rallied strongly last week as renewed concerns about Middle Eastern supply disruptions lifted the geopolitical risk premium. However, prices retreated today following indications that Washington could ease restrictions affecting Russian fuel exports.

UKOil traded around $108 a barrel during today's Asian session, while USOil was nearer $97–98.

Whether additional Russian supply can meaningfully relieve the market remains uncertain. Infrastructure damage, implementation questions and continuing risks around the Strait of Hormuz complicate the outlook.

For central banks, the concern is straightforward. Sustained high energy prices can erode household purchasing power, increase business costs and make inflation harder to contain, even as economic growth slows.

Gold hovered around $4,180 an ounce today, supported by lower Treasury yields, while the dollar remained near ¥158 against the Japanese currency.

What matters next

The immediate focus is corporate earnings.

Technology companies must demonstrate that the AI investment cycle can deliver returns consistent with increasingly demanding valuations. Strong revenue growth alone may no longer be enough.

The next US personal consumption expenditure inflation report will also be important. Investors need to establish whether September's price pressures are beginning to spread more persistently beyond energy.

Elsewhere, attention will fall on European sovereign yields, the approaching UK Budget and the implications of China's latest economic figures for commodity demand.

Perhaps the most revealing indicator, however, will be credit markets. If financing conditions deteriorate further for data-centre developers and other heavily indebted technology businesses, a correction in share prices could eventually become a broader investment slowdown.

That risk has increased, but it is not yet evidence that the AI infrastructure cycle has fundamentally weakened.

Final thought

The AI boom has not run out of demand. It has run into the price of money. The next phase will be judged less by how much companies are prepared to spend and more by what that spending can realistically earn.

Sources and References

US CPI - Bureau of Labor Statistics
US PPI - Bureau of Labor Statistics
US Retail Sales - US Census Bureau
Global Markets & AI Sell-off - Reuters
Federal Reserve Outlook - Reuters
Bank of England - Reuters
China GDP - Reuters
Oil & Geopolitics - Reuters