The Fed is pausing, not pivoting

The US economy continues to show an uncomfortable combination of resilience and inflation pressure. September's ISM services index slipped to 54.9 from 55.4 in August, but the underlying figures offer little comfort to policymakers. New orders remained strong at 59.8, while the prices-paid index rose to 74.0, its highest reading since July 2022.

The message is fairly straightforward. Demand has eased slightly, but businesses are still dealing with substantial cost pressures. With energy prices elevated and supply chains under strain, the Federal Reserve has little reason to declare victory over inflation.

Minutes from the Fed's 15–16 September meeting reinforce that view. Officials unanimously raised the federal funds target range by 25 basis points to 3.75–4.00%, and most believed another increase would probably be appropriate before year-end. The disagreement was largely about how much additional restraint the economy needs and how quickly it should be delivered.

For now, patience appears to be winning. Markets assign roughly a 19% probability to another rate increase in October, rising to around 85–86% for a hike by December.

That makes Wednesday's inflation report particularly important. Consensus forecasts point to headline CPI rising 0.6% month on month and 3.7% annually, while core inflation is expected at 0.2% and 2.5%, respectively. A hotter reading would complicate the case for waiting. A result broadly in line with expectations would probably leave December as the more likely opportunity for another move.

Equities are holding up, but not everyone is participating

Wall Street managed another positive week despite borrowing costs remaining uncomfortably high. The S&P 500 gained 1.2%, the Dow advanced 0.9% and the Nasdaq rose 0.6%. Smaller companies were less fortunate, with the Russell 2000 losing 0.9%.

That divergence deserves attention. Investors are still prepared to pay for businesses with strong earnings and exposure to artificial intelligence, but their enthusiasm does not extend equally to companies more dependent on affordable financing.

The distinction matters as third-quarter earnings season gets under way. Analysts expect S&P 500 profits to increase by more than 30% from a year earlier, with technology accounting for much of the growth.

These are demanding expectations. Strong results could provide further support for valuations, but companies will have to demonstrate that the enormous sums being committed to AI infrastructure are generating commercially sustainable returns. Good earnings may not be enough if investors were expecting exceptional ones.

Bond markets are adding another layer of pressure. The US ten-year Treasury yield finished Friday near 5.24%, retreating from its recent 24-year high after stronger demand at government debt auctions.

That provided some relief, although the underlying problem remains. Heavy government borrowing is competing with substantial corporate financing requirements, including the debt being raised to fund AI infrastructure. Investors are demanding greater compensation to commit capital for longer periods, and that affects valuations across financial markets.

France is testing Europe's fiscal credibility

Across the Atlantic, France has become an increasingly important source of financial anxiety.

French ten-year government bond yields have risen almost 80 basis points since the beginning of September, approaching 5% and reaching levels last seen in July 2002. Eurozone finance ministers have urged Paris to produce a credible 2027 budget, but investors remain sceptical that meaningful fiscal consolidation can be delivered in the current political environment.

The problem extends beyond the size of France's deficit. Political fragmentation makes spending restraint difficult, while higher borrowing costs worsen the fiscal arithmetic. France also faces limits on its eligibility for emergency ECB support under the current framework.

French bonds recovered some ground late last week, but it would be premature to regard that as a resolution. The more important question is whether investors continue to demand a substantial premium for holding French debt relative to German Bunds.

The currency market is reflecting these concerns. The euro has declined for five consecutive weeks and was trading around $1.121 today. The dollar index, meanwhile, held near a 17-month high of 102.17, while the yen remained weak at approximately ¥158.2 per dollar.

Higher US interest rates are supporting the dollar, but European fiscal uncertainty is adding to its appeal. For currency markets, the issue is no longer simply the relative direction of central-bank policy.

Oil offers relief, but the risks have not disappeared

Energy markets began the week on a softer footing after another turbulent period.

Brent had finished last week around $104.72 a barrel, while WTI closed near $91.85. Both benchmarks retreated in today's Asian trading, with Brent falling towards $103.38 and WTI to approximately $90.29.

The immediate catalyst was President Donald Trump's announcement of an energy ceasefire involving Russia and Ukraine, together with the possibility of additional Russian energy exports. The announcement has raised hopes of increased supply, but important questions remain over whether such an arrangement exists in a workable form and whether additional volumes can reach international markets.

In other words, prices are responding to a possibility, not a confirmed improvement in supply.

China may provide some additional relief. According to trade sources, Beijing has approved around 3.7 million metric tonnes of diesel, petrol and jet-fuel exports for October. Additional refined products could help ease tightness in parts of the market, although they cannot eliminate the risks created by disruption to crude supplies and international shipping.

Gold, meanwhile, remains remarkably resilient. The metal gained more than 1% last week and was trading around $4,200 an ounce this morning.

Its strength is noteworthy given the historically elevated level of Treasury yields. Ordinarily, attractive returns on government bonds make a non-yielding asset such as gold less appealing. Continued buying suggests that concerns about geopolitical instability, public finances and policy uncertainty remain powerful influences on investor behaviour.

What to watch

Wednesday's US CPI release is the week's principal macroeconomic test. Thursday brings producer prices and retail sales, providing further evidence of whether higher input costs are feeding through to consumers and whether household spending can maintain its momentum.

Corporate earnings will be equally important. The major US banks begin reporting this week, offering an early assessment of credit conditions, lending activity and funding pressures. Taiwan Semiconductor's results should provide another useful test of whether AI-related investment is translating into sustained demand for physical infrastructure.

In Europe, the French–German ten-year bond spread warrants close attention. Renewed widening would suggest that investors remain unconvinced by France's fiscal outlook, particularly if pressure begins to spill over into other sovereign markets.

Oil prices may also prove decisive. Any credible confirmation of a Russia–Ukraine energy arrangement could ease inflation expectations. If the announcement fails to translate into additional supply, however, markets may have moved too quickly to price in relief.

Final thought

There is something increasingly uncomfortable about the way markets are behaving. Equities continue to reward earnings growth, particularly in technology, even as government borrowing costs remain near generational highs and energy prices threaten to keep inflation elevated.

For the moment, investors appear willing to look beyond those risks. Perhaps strong corporate profits will prove sufficient to justify that confidence. But with valuations demanding, fiscal credibility under scrutiny and central banks still concerned about inflation, there is less room for things to go wrong. The danger is not necessarily that growth suddenly disappears. It is that growth remains healthy while the cost of financing it becomes progressively harder to ignore.

Sources and References

• federalreserve.gov
• reuters.com
• reuters.com
• reuters.com
• reuters.com
• bls.gov