The US Economy Is Still Flexing Its Muscles

Here are some of the biggest stories from last week:

• Business activity in the eurozone saw a bigger-than-expected drop in October.
• The European Central Bank left interest rates unchanged.
• The US economy grew at the fastest pace in nearly two years last quarter.
• The 10-year Treasury yield crossed above 5% for the first time in 16 years.
• Gold’s relationship with real yields has broken down.
• Bitcoin surged past $35,000 for the first time since May last year.

Dig deeper into these stories in this week’s review.

Macro

The eurozone’s purchasing managers' index (PMI) gauges business activity in the bloc. And based on the latest results, things are going from bad to worse. The eurozone PMI dropped for a fifth consecutive month, from 47.2 in September to a three-year low of 46.5 in October. That’s well below the crucial 50-mark that separates expansion from contraction, and defied economist expectations for a slight improvement to 47.4. Given this lackluster start to the current quarter and the anticipated economic contraction last quarter, the eurozone is most likely headed for a technical recession (defined as two back-to-back quarters of negative growth). This downturn can be attributed to several headwinds, including the European Central Bank's aggressive rate-hiking campaign, a global economic slowdown, and rising energy prices due to renewed conflict in the Middle East.

Speaking of which, the ECB left interest rates unchanged this week, bringing to an end its unprecedented streak of 10 consecutive hikes that took borrowing costs from minus 0.5% to 4% in just over a year. The decision was widely expected by analysts in the wake of eurozone inflation more than halving from its peak and the economy showing signs of weakening. But the central bank did not rule out another rate increase, while adding that it was totally premature to discuss any potential cuts.

Finally, the US economy grew at the fastest pace in nearly two years last quarter, driven primarily by a surge in consumer spending. Growth in the world’s biggest economy soared to an annualized rate of 4.9%, a significant increase from the pace seen in the second quarter and ahead of the 4.5% forecast by economists. Personal spending, a key driver of economic growth, surged by 4% despite higher prices and a big increase in borrowing costs. The enduring strength of the job market and subsequent boost in household demand is the primary factor behind this resilience, which is complicating the Fed’s efforts to bring inflation down to its 2% target. Looking ahead, the sustainability of economic momentum in the fourth quarter as well as inflation’s future trajectory will influence the Fed’s officials' decision on whether to hike interest rates further. Many economists anticipate a slowdown in growth towards the year's end, as higher borrowing costs curb major purchases and student loan payments resume.

Bonds

The 10-year Treasury yield briefly crossed above 5% for the first time in 16 years on Monday, extending a multi-week rout in bonds. The selloff has been fueled by expectations that the Fed will maintain interest rates at their current high levels for longer, and that the US government will further boost bond sales to cover its widening budget shortfall. In fact, growing concerns over the government’s near $2 trillion annual budget deficit prompted Fitch Ratings to downgrade the US’s credit rating in August, adding upward pressure to yields. The latest bond rout means Treasuries with maturities of 10 years or longer have now declined by nearly 50% since their peak in March 2020, putting them on course for an unprecedented third year of annual losses.

But it’s not just bond investors that will be feeling the pain: the 10-year Treasury yield is often considered the risk-free rate against which all other investments are benchmarked. So a higher yield could lead to declining values in other asset classes too. What’s more, the yield impacts borrowing rates for households and businesses. The average rate on a 30-year fixed mortgage, for example, soared to around 8% in recent weeks, while the cost of servicing credit card bills, student loans and other debts has also climbed. The big concern now is that these elevated borrowing costs, which are already hindering the US economy's momentum, could dent consumer spending and business investment enough to bring about a recession.

And 5% could be just the start because: a recent study by Bloomberg Economics, for example, suggests that the cumulative effects of persistently high government borrowing, increased spending on climate change initiatives, and accelerated economic growth could result in a nominal 10-year bond yield of around 6%. That could help explain why futures traders are more than ever betting on bonds to drop.

Commodities

Typically, gold prices exhibit an inverse relationship with real (i.e. inflation-adjusted) Treasury yields. As real yields increase, gold often declines, and the opposite holds true. This correlation becomes clearer when considering the two main factors influencing real yields: government bond yields and inflation. If nominal yields increase, the "opportunity cost" of holding gold, which offers no income, rises. Consequently, gold becomes less appealing when bonds offer higher returns, leading to a drop in its price. On the other hand, when inflation surges, fiat currencies and future bond payouts lose value due to rising consumer prices. In such circumstances, investors are drawn to gold’s stability and the value that’s baked into its limited supply.

However, gold’s relationship with real yields has broken down in the face of the substantial rise in real yields since the start of 2022, and there are a few explanations for this shift. First, gold demand has been propped up by record buying from central banks over the past 18 months, as some countries looked to diversify their reserves to reduce their reliance on the dollar after the US weaponized its currency in sanctions against Russia.

Second, gold has been buoyed by strong investor demand in China, as a property crisis, a falling yuan, and tumbling yields boost demand for the shiny metal. This booming demand is reflected by the local price of gold in Shanghai, which surged last month, at times commanding a record premium over international prices of more than $100 an ounce. This contrasts with a decade-long average premium of less than $6.

Third, gold's reputation as a safe-haven asset has recently bolstered its performance amidst the ongoing geopolitical and economic turbulence. The price of the precious metal surged as much as 10%, hitting a five-month high, after conflict broke out in the Middle East earlier this month. And with central banks significantly raising interest rates – a move often resulting in financial market instability, as evidenced by the spate of bank failures earlier this year – it's understandable that investors have been drawn to gold.

Crypto

The price of bitcoin surged past $35,000 for the first time since May last year, driven by anticipation of increased demand from ETFs. The possible approval in coming weeks of the first US spot bitcoin ETFs – something firms like BlackRock, Fidelity, Invesco, Grayscale, and WisdomTree have been trying to get authorized for years – is fueling increased speculation for the cryptocurrency. These proposed funds would let investors access bitcoin by simply purchasing shares, similar to buying stock, eliminating the need to own the crypto in a digital wallet. That whole new way to easily invest in bitcoin without directly owning the asset could boost its value, which is why traders are buying in anticipation of the potential US approval of the first spot bitcoin ETFs.

Next week

• Monday: Eurozone economic sentiment (October). Earnings: McDonald’s, Pinterest.
• Tuesday: Bank of Japan interest rate announcement, Japan unemployment rate, industrial production, and retail sales (all September), eurozone GDP (Q3), eurozone inflation (October), US consumer confidences (October). Earnings: AMD, Pfizer, Caterpillar.
• Wednesday: Fed interest rate announcement. Earnings: PayPal, Qualcomm, Airbnb, Kraft-Heinz, Mondelez.
• Thursday: Bank of England interest rate announcement. Earnings: Apple, Moderna, Novo Nordisk, Palantir Technologies, Starbucks, Block, Coinbase, Shopify.
• Friday: US labor market report (October), eurozone unemployment rate (September), China PMIs (October).