US bond sell-off sparked by inflation worries

The sell-off deepened in the final days of the month as investors priced in rising expectations that the Federal Reserve (Fed) would need to take action in September to combat the eruption of inflationary pressure triggered by the ongoing US-Iran conflict. UK and European natural gas prices have spiked reflecting anticipation of winter demand. Fed Chair Kevin Warsh warned in his annual Jackson Hole conference speech that inflation is expected to remain above target, and markets are now pricing in a more than 50% probability that US interest rates will rise in mid-September at the next Fed meeting.

With the October Budget looming, the new Chancellor of the Exchequer John Healey faces pressure to improve the UK fiscal position and rectify a growing deficit. The UK recorded an unexpected budget deficit of £1.8bn in July, underpinning concerns that October’s Budget will add to an already challenging economic backdrop. The UK economy continues to run hot in the face of wider geo-political concerns, with CPI inflation rising to 2.9% in the 12-months to July, unemployment above forecasts and household energy bills set to hit a 3-year high from October when the new Ofgem price cap kicks in. While the UK economy actually grew by 0.4% in the second quarter of the year, forecasts expect growth to slow substantially in the remainder of 2026.

In Japan 10-year government bond yields reached their highest level in 30 years. Japan has been struggling with a weaking domestic currency which triggered an unprecedented joint intervention by the US and Japan at the end of July.

Global equity market performance was choppy but positive in August. A fresh wave of AI-related optimism triggered by some strong earnings reports saw investors flood back into stocks in the first half of the month. However, bond market pressures cast a gloomier shadow over performance in the second half of the month to temper overall performance. Sterling credit spreads remained broadly flat and still well below long-term averages.

Despite the struggles of the US bond market, UK fixed interest gilts posted marginally positive performance. Index-linked gilts benefitted from a marginal increase in inflation expectations. On a low-risk basis, the aggregate funding level of UK defined benefit pension schemes was broadly flat over August.

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