Risk sentiment takes a pause, as all eyes on UK bond auction

The prevailing narrative for financial markets this month is that the AI boom combined with central bank support and rate cuts will sustain the equity market rally for the long term. Thus, the recent wobble in stocks, US stocks suffered some modest losses in recent days, has not led to a spike in volatility or fears that the sell off could deepen.

No signs of a bubble in AI

The Vix index is currently trading at 16, which is well below the 12-month average of 18.8. Theare are concerns that the AI trade could be a bubble, however, in the last 3 months the best performing stocks on the S&P 500 have not been the big AI players, Warner Brothers Discovery is higher by 81% and Paramount is higher by 62%. Thus, bubble concerns could be overdone.

Earnings season could be the next big test for AI. US mega cap tech stocks are the biggest drivers of revenue and earnings growth in the S&P 500, so this will make the Q3 earnings season vital to see if the AI trade can continue. Another quarter of strong earnings reports for these companies could drive further gains.

Division at the Fed

Right now, it looks like we have reached a permanently high plateau for stock indices, hence the pause in momentum has only triggered mild losses so far. The one risk for stocks that has yet to be priced in is a split at the Federal Reserve.  In the past week, Treasury bond yields have risen, reversing weeks of declines. This is in response to some mixed commentary from Federal Reserve members.  Interestingly, since August, Bloomberg’s Fed Speak Index has been trending higher. Although the newest member, Stephen Miran, is an uber dove, other longer-term members are sounding concerned about inflation and cutting rates when the economy remains strong. Most recently, the governor of the Federal Reserve bank of San Francisco, Mary Daly, said that further interest rate cuts are likely to support the labour market, but further cuts should be approached with caution.

Some in the market think that Stephen Miran’s views on monetary policy will reflect those of the next chair, once Powell steps down in May 2026. Thus, the market is happy to ignore the less dovish members of the Federal Reserve, for now. This is also reflected in the continued strength in the gold price, he gold price is higher by another $10 today, at $3,747 per ounce, as investors continue to seek out an inflation hedge.

UK bond market auction in focus

There has not been too much economic data released this week, so the focus may shift to government debt auctions. Later today, the UK is looking to sell £1.25bn of 2034 bonds, and £750mn of 2038 bonds. This will be a key test for demand, as we lead up to the Budget. On Wednesday, there was more talk of scraping the two-child universal credit benefit cap, which could cost the government £3.5bn a year, money it does not have. There are also concerns that another £30bn of tax rises will be needed in this budget, which if true would mean that the government has increased taxes by more than £70bn in just over 1 year. Thus, fears are growing of another budget that will throttle UK economic growth.

Today’s auction will be a key test of demand, earlier this week demand for 5-year and 30-year debt was the lowest in 2 years. The UK has already started to offer shorter dated bonds due to waning pension fund demand for long dated bonds. Thus, if we see reduced demand for medium duration bonds, then this could trigger a fresh wave of bond market jitters for the UK.  Weak demand could be the latest blow to the government and suggests that financial markets have lost faith in the government’s ability to manage the economy. This is worrying and comes at a time when the government is borrowing money at rates lasty seen during the pandemic.

A series of U-turns on spending pledges, along with a productivity downgrade from the OBR, could be the next threat to the UK bond market. Added to this, the risk that left-wing Andy Burnham could challenge Kier Starmer for the leadership may also lead to further jitters in the bond market. Burnham dismissed bond market concerns in a recent interview, which could lead to more discomfort for investors in the coming weeks.

Dollar pauses, as crypto sinks

Elsewhere, all eyes will be on the US initial jobless claims data due for release later today. The dollar is weakening after a strong first half of the week, allowing EURUSD to attempt a break above $1.1750, as we wait for the ECB’s economic bulletin later this morning.  As risk sentiment takes a pause, crypto is lower once again, and Bitcoin is lower by $1,798, so far on Thursday.