Last week ended with a sentence. Kevin Warsh said the Fed cannot steer the price of oil, and the bond market thanked him for it: the ten-year yield fell back to around 4.93 percent. The reward lasted three sessions. By Wednesday the ten-year had closed at 5.11 percent, its highest since 2007, and on Thursday it touched 5.22 percent intraday.
Oil was not the trigger. Brent fell below 100 dollars on Tuesday for the first time this month, on news of direct talks between Washington and Tehran. What drove yields higher was a set of business surveys showing the American economy accelerating rather than slowing. A strong economy is supposed to be good news. This week it was priced as a cost.
That is the shift worth naming. The market has stopped asking whether the Fed will look through an energy shock. It is now asking how high rates must go in an economy that no longer needs them to be low.
Growth the Fed cannot ignore
On Wednesday S&P Global reported the fastest growth in American business activity in more than five years. Manufacturing and services both improved, capacity came under strain and input costs rose faster. The same day Governor Michael Barr said that in his base case "further policy adjustments are likely to be needed" to bring inflation back to target in time. On Thursday Philadelphia Fed president Anna Paulson added that inflation still demands attention.
Pricing followed. The probability of a hike at the 28 October meeting rose from around 55 percent on Tuesday to roughly 70 percent by Thursday, and futures now lean toward moves at both remaining meetings of the year. That goes further than the committee itself, where twelve of eighteen participants pencilled in one more increase.
The gap matters. Last week the Fed explained that it would act against expectations, not against the oil price. This week the market concluded that expectations are not the only problem. An economy growing at this pace can carry a higher rate, and it will probably be given one.
Government bond yields break through five percent
The selloff ran along the whole curve. The five-year crossed 5 percent on Wednesday for the first time since 2007, the two-year rose to around 4.9 percent, its highest since 2023, and the thirty-year reached 5.50 percent intraday on Thursday, a level last seen in June 2004. A weak auction of 70 billion dollars in five-year notes added momentum.
The Treasury offered no relief this time. In August its enlarged buybacks steadied yields on long-dated government bonds. This week the latest operation fell short of what the market had expected, and yields kept rising. Three weeks ago this series observed that support is not a solution. This week the difference became visible.
The composition of the move says more than its size. Market-based long-term inflation expectations have stayed relatively contained. What has risen is the real yield, the return investors demand after inflation. That is not a market fearing an inflation spiral. It is a market recalculating what money should cost in an economy that keeps growing. For households the arithmetic is immediate: the thirty-year fixed mortgage rate has crossed 7 percent.
Equities hold, but on a narrow base
Equities began the week as if nothing were wrong. Monday brought the best session for the S&P 500 and the Nasdaq since early August, and on Tuesday the Nasdaq set an intraday record as oil fell. Wednesday reversed it. The S&P 500 lost 0.8 percent to 7,706, the Dow 0.7 percent to 51,512 and the Nasdaq 1.1 percent to 26,936, with ten of eleven sectors lower and small caps losing more still. The VIX rose to around 15.8, still low.
Thursday closed almost flat, with the S&P 500 at 7,707, but the index concealed more than it showed. Most of its members fell. Oracle lost more than 5 percent after sending a force majeure notice on its New Mexico data centre project, while the gains came from a handful of large names such as Meta. The Dow slipped 0.3 percent.
Smaller companies feel the cost of borrowing first, and they are feeling it now. An index that holds its level while most of its constituents decline is not a strong market. It is a narrow one.
Europe grows through its rate increases
The euro area delivered its own surprise. The flash composite PMI rose to 53.1 in September, its highest since April 2023, where a decline had been expected. Services led at 53.0. More important for the ECB, the measure of prices charged for services reached its highest since early 2024. The energy shock is no longer confined to energy.
The bond market took note. The German ten-year rose above 3.5 percent, its highest since 2009, and the French ten-year reached 4.61 percent, the highest since 2008, widening the spread over Bunds to 108 basis points from 91 two weeks ago. Bundesbank president Joachim Nagel said oil is becoming an increasingly important factor in policy decisions, and chief economist Philip Lane warned that a new energy surge could keep inflation elevated for longer. Markets price around 35 basis points of further increases this year, which keeps the meeting of 29 October open.
Two weeks ago the argument here was that raising rates does not reopen a strait. That still holds. But once firms can pass higher energy costs on to their customers, the problem moves from the strait to price setting at home, and that is where rates do work.
Oil returns, gold does not
Brent fell for six sessions in a row into Tuesday, dropping below 100 dollars as American and Iranian negotiators met for three hours on the sidelines of the UN General Assembly. Wednesday and Thursday undid that. After Houthi missiles targeted the Saudi cities of Yanbu and Taif, Brent touched 108.23 dollars intraday and settled at 106.60 on Thursday, with WTI at 94.61. Reports of a phased deal, under which Iran would allow passage through Hormuz in return for an end to the American naval blockade, capped the rally without reversing it. Brent is up more than 17 percent in September.
Gold went the other way. It lost 1.7 percent on Wednesday to settle at 4,289 dollars and slipped on Thursday to around 4,270, its lowest since 17 September and more than twenty percent below January's record. The dollar index rose to around 101, its highest since late July.
Last week gold recovered because the Fed declined to chase the oil price. This week its competitor was not the Fed but the Treasury market. A metal that pays nothing is hard to hold against a real yield that keeps climbing.
Where this leaves the markets
On 30 September the August core PCE arrives, the gauge this series follows. It stood at 3.3 percent for four months through July, and Warsh put the level at roughly 3.2 percent at his press conference. A reading at or below that would be the first sign in half a year that the underlying trend is moving. A higher reading would all but settle October, where markets already price around 70 percent odds of a hike.
Three dates run alongside it. The Fed decides on 28 October, the ECB a day later, and on 4 November the Treasury announces how large its buybacks will be after this quarter. Behind all three sits Hormuz, where a phased deal is being discussed but not yet agreed.
Last week the Fed said oil is not the variable. This week the bond market replied that growth is. The Fed has found its voice. The bond market has found a louder one.
