When policy starts to work
Last week safety had one address: US government debt. This week the Fed explained why. According to Chair Kevin Warsh, the "overwhelming judgement" on the rate-setting committee is that monetary policy is "starting to work". The September hike is feeding through to credit and to asset prices.
The data argued against him. The US economy grew at an annualised 3.4 percent in the third quarter. Core PCE rose to 3.1 percent. Two policymakers wanted to raise rates immediately. Yet on Thursday the ten-year yield fell to 4.94 percent, its lowest in seven weeks.
Policy is working, then, but not on inflation. It is hitting first the companies that need to find hundreds of billions to build artificial intelligence. Alphabet lost 12.6 percent on Thursday and Amazon followed after hours. The Fed is raising rates to cool inflation. The market sees something else cooling first.
The Fed sees its policy working
Wednesday's decision was no surprise. The target range stayed at 3.75 to 4.00 percent. The vote was the story: 10 to 2. Governor Lisa Cook and Cleveland Fed President Beth Hammack voted for an immediate quarter-point hike. Warsh called it "a family fight, a serious, sober discussion".
He gave nothing away on December. He did call growth strong and financial conditions tighter, though he was "unwilling and unable" to call them tight. Market participants, he said, are becoming "somewhat more discerning in their capital allocations". On AI he was strikingly open. He had been sceptical that interest rates affect AI investment. He has since seen that they do.
After the press conference, markets priced a probability of around 85 percent for a hike on 9 December. By Friday it was about 75 percent. The Fed targets inflation. Its own chair pointed to where policy lands hardest.
The data gives no reason to relax
This week's figures leave little room for patience. Headline PCE inflation came in at 3.6 percent in September. Core PCE, the measure this series follows, rose to 3.1 percent, from 3.0 in August and the highest since May. The flash composite PMI eased to 57.6 in October, but selling prices rose at the fastest pace since August 2022.
An economy running this hot, with inflation still rising, normally justifies higher rates. On Wednesday the bond market reacted exactly that way. Straight after the press conference the ten-year yield rose to 5.04 percent and the thirty-year to 5.37. A day later the move was fully reversed. On Thursday the ten-year fell more than 11 basis points to 4.94 percent, against around 4.99 a week earlier.
That fall did not come from the inflation data. It came from big tech earnings. Investors are not buying Treasuries because they expect the Fed to ease. They are buying them because they expect the tightening to break something.
Big tech picks up the bill
Alphabet opened the round on Wednesday evening. Revenue fell short of expectations, advertising grew at its slowest pace in five quarters, and management conceded that AI Mode queries monetise more slowly than traditional search. Capital spending rose by 6.5 billion dollars in a single quarter to 51.4 billion, and free cash flow turned more negative. The shares lost 12.6 percent, around 500 billion dollars of market value.
Amazon followed after Thursday's close. Revenue rose 12 percent to 201.9 billion dollars and AWS grew 39 percent, but earnings per share missed. The company is sticking to 220 billion dollars of capital spending this year. Over the past twelve months free cash flow stands at minus 42.4 billion. The shares fell 7 to 10 percent after hours. Microsoft beat expectations and guided to Azure growth of 49 to 50 percent, but its stock closed flat.
The rest of the market told a different story. On Thursday the Nasdaq fell 1.4 percent, while the equal-weighted S&P 500 gained more than 1 percent and health care rose 2.5 percent. From last Friday through Thursday the S&P 500 gained 1.3 percent, the Nasdaq 0.9 and the Dow 0.2. The market is not selling equities. It is selling growth that has to be paid for with capital.
Europe loses its anchor
On Thursday the ECB kept its deposit rate at 2.5 percent, after two hikes in five months. The news lay elsewhere. Christine Lagarde will step down in February 2027, nine months before her term ends. Isabel Schnabel leaves the executive board in January for a post at the IMF, and chief economist Philip Lane's term expires in May. European leaders want to choose a successor before France's presidential election in the spring. The Dutch government backs Klaas Knot, Spain backs Pablo Hernández de Cos.
The ECB warned that rising energy prices are pushing inflation up and growth down. Markets still see another hike in December as a real possibility. The euro area grew 0.4 percent in the third quarter, against 0.2 expected, helped by a 5.5 percent jump in Ireland. The Netherlands and Spain grew 0.6 percent, Germany 0.2. Italy stagnated and France contracted by 0.1 percent, while French inflation rose to 3.8 percent, the highest since late 2023.
In Tokyo the Bank of Japan held at 1.25 percent but raised its inflation forecast for 2027. Europe now faces a central bank in transition, just as France is shrinking and getting more expensive at the same time. That is exactly when an anchor is needed most.
Oil rises, gold slips below 4,000
Brent traded around 116 dollars on Friday for the expiring December contract. That is almost unchanged from a week earlier, after a dip toward 114 dollars. The dip came when it emerged that Iran had received a letter from Vice President JD Vance aimed at reviving talks. Tehran has not yet replied. On Friday the Revolutionary Guards said three tankers had hit mines on a southern route near Hormuz. US Central Command rejected the claim. The Houthis said they had attacked the Saudi refineries at Ras Tanura and Rabigh. Brent is heading for a gain of almost 11 percent in October and WTI for around 14 percent. It would be the fourth monthly gain in a row.
Gold fell on Friday to around 3,985 dollars an ounce. That is roughly 1 percent lower than last week and almost 5 percent lower over the month. A Fed more likely to hike than cut makes a metal that pays no interest less attractive. In Israel, Tuesday's election produced no majority. Netanyahu's bloc won 53 of 120 seats, and the opposition led by Gadi Eisenkot 48.
The classic hedge against inflation is losing ground while the oil price fuels inflation. Investors are not choosing protection against rising prices. They are choosing yield.
Where this leaves the markets
Next week is about politics and debt. On 3 November the United States elects a new Congress. On 4 November the Treasury sets out its borrowing plans, and the Israeli result should be certified. On 5 November French unions strike. On 6 November the US jobs report for October arrives, the last major data point before the Fed decides on 9 December. Brent rolls to the January contract on Monday, which trades around 4 dollars lower.
Two weeks ago investors fled to the state. Last week they did so with a force not seen since a bank collapsed. This week the Fed confirmed that its policy is starting to work, and the market showed where. Inflation is still rising. The cash flows of the world's largest companies are draining. If the Fed hikes in December, it will hit first the investment that carried this year's growth. The central bank is aiming at inflation. The market expects a different casualty.
