Her Majesty The Queen, 1926 – 2022

Darqube pays its respect for Her Majesty Queen Elizabeth II, who passed away peacefully at her estate in Balmoral on Thursday at the age of 96. Ascending the throne in 1952, Queen Elizabeth II dedicated her life to public service with dignity and devotion for more than seven decades, inspiring so many around the world. During this sad time, Darqube offers its condolences to the Royal Family as well as the people of the United Kingdom and the Commonwealth.

This week

The week started off on the wrong foot, especially in Europe after Russia cut off a key gas pipeline to the region in a move that sent shockwaves throughout European markets. A few days later, the European Central Bank (EBC) hiked rates by a historic 75 basis points. It joins a growing list of central banks aggressively increasing rates in response to soaring inflation, and their collective actions have brought a four-decade bull market in bonds to an end. Investors in emerging market bonds are also feeling the pain on the back of the stronger dollar. In the US, the yields found on 5-year and 10-year inflation-protected Treasuries are back near multi-year highs, pressuring several asset classes including crypto, which saw its market cap dip below $1 trillion this week. Finally, OPEC+ unexpectedly decided to cut output in October, sending oil prices higher at the start of the week.

Macro

Over the weekend, Gazprom indefinitely cut shipments on the Nord Stream pipeline – Europe's main gas import infrastructure – to zero (the pipeline was previously operating at 20% capacity). Europe saw this coming and in an attempt to prepare for the prospect of a full Russian cutoff, the bloc has been building up its storage and has a buffer for at least part of the winter. Still, Russia’s move sent shockwaves throughout European markets when they opened on Monday: stocks tumbled, gas prices soared more than 30%, and the euro dropped to a new 20-year low against the dollar. Not a surprise considering that the worsening energy crisis is increasing the risk of a eurozone recession at a time when soaring consumer prices are pressuring the ECB to increase interest rates.

Speaking of which, after raising interest rates by 50 basis points in July, the ECB hiked rates by a historic 75 basis points on Thursday – its latest effort to cool down record-high inflation that has spread beyond just energy prices. The hike brings the ECB’s deposit rate to 0.75% – its highest level since 2011. But the central bank isn’t done yet, pledging “several” further increases even as the bloc’s economic outlook worsens. Case in point: in updated forecasts, the ECB slashed its forecast for economic growth in 2023 and 2024 while raising its inflation outlook for this year and next.

How far will the ECB go? No one knows for sure but economists polled by Bloomberg reckon the central bank will raise the deposit rate until it reaches 1.5%, which is broadly where they see the “neutral” interest rate at – that is, the interest rate level that neither stimulates nor constricts the economy.

The ECB is one of many central banks aggressively increasing interest rates in response to soaring inflation, and their collective actions have brought a four-decade bull market in bonds to an end. The Bloomberg Global Aggregate Total Return Index of government and investment-grade corporate bonds has now fallen more than 20% from its 2021 peak – the biggest drawdown since its inception in 1990 and officially marking a bear market in global bonds. What’s more, with bonds and stocks falling in tandem, it’s creating a very difficult environment for investors – especially those who utilize traditional portfolios predominantly made up of the two asset classes.

Investors in emerging market (EM) bonds are also feeling the pain. See, on top of rising interest rates, EM bond markets are feeling the effects of a stronger dollar. As the greenback rises, it becomes more expensive for EM countries to service their dollar-denominated debt, so the price of the bonds falls as investors demand higher yields to compensate for the extra risk. That comes on top of all the other issues EM countries are currently contending with – an energy crisis, rising inflation, slowing economic growth, and the increased threat of social unrest, to name a few.

All in all, Bloomberg's hard currency EM bond index has fallen 15% this year, compared with a 10% slide in the local currency EM bond gauge, and is on track for its worst annual performance since 2008. That’s pushed the spread between EM dollar-denominated bonds and local currency equivalents to its highest level since the financial crisis. Put differently, investors haven’t been this worried about EMs paying their dollar-denominated debt (compared to their borrowings denominated in local currencies) since 2008.

Stocks

After being stuck in negative territory for most of the pandemic years, real (i.e. inflation-adjusted) Treasury yields are breaking out, with the yields found on 5-year and 10-year inflation-protected Treasuries back near multi-year highs. Real yields are seen as the true cost of money, so when they rise, it makes borrowing more expensive and reduces the appeal of many assets – especially speculative ones (like unprofitable tech stocks or crypto) and ones that don’t pay any income (like gold).

Problem is, despite their recent spike, real yields are expected to head even higher in light of the Federal Reserve's determination to tighten financial conditions to try to bring down the country’s sky-high inflation. That suggests further pressure on virtually every asset class as well as the economy, with Goldman Sachs recently saying that 10-year real yields are moving closer to levels that would materially restrict economic activity. Strategists at Nomura, meanwhile, reckon that any push to new multi-year highs in real yields would likely go hand-in-hand with a new leg down in stocks. You can see why in the graph below, which shows how global equity prices move inversely to the 10-year US real yield.

Commodities

Probably the last thing the world needs right now, but oil surged at the start of the week as OPEC+ unexpectedly decided to cut output in October – the first supply cut by the group in more than a year. OPEC+ – the group of the world’s biggest oil-producing countries and their allies – plan to trim production by 100,000 barrels a day next month, effectively reversing a symbolic output hike of the same volume in September that was made in response to lobbying from the US president. The cut comes just two weeks after the Saudi energy minister expressed his unhappiness with the latest drop in oil prices that came amid growing fears of a recession in Europe and weaker oil demand from China.

Crypto

The crypto sector’s total market cap dipped below $1 trillion this week. That comes after bitcoin’s latest drop, with the biggest crypto in the world now flirting with this year’s low of around $17,500 that was hit in June in the wake of blowups at crypto lenders and hedge funds. Surging real yields (which we discussed above) are reducing the appeal of speculative assets, and crypto is no exception. All in all, the MVIS CryptoCompare Digital Assets 100 index of the largest tokens is down about 60% this year with many traders anticipating further pain as real yields go higher still.

Next week

Next week is dominated by economic data coming out of the US and UK. The week will start off with the UK’s GDP report for July, and a worse-than-expected reading could send the British pound lower a week after it hit its lowest level against the dollar since 1985. A day later we’ll get further clues on the British economy with the release of the labor market report showing average earnings and the unemployment rate for August. On the same day, we’ll also get the US inflation report for August, which will have a big impact on the Fed’s next interest rate decision later this month. A day later we’ll see the release of the UK’s August inflation report. Finally, retail sales data for both the US and UK is scheduled for Thursday and Friday respectively.