Week 37

Macro

The Middle East energy shock moved from geopolitical risk premium toward physical supply disruption this week, while global activity remained surprisingly resilient. Brent rose 8.65% Friday-to-Friday from $96.28 to $104.61/bbl and reached $109.97 intraday, while WTI gained 9.37% to $100.05. Iranian exports remain a fraction of their pre-war 1.5-1.7 mb/d level, Saudi Arabia closed the East-West pipeline after drone attacks from Iraq, Hormuz remains under active military contest, and Houthi forces seized Mayun island and Mokha around Bab el-Mandeb, a route carrying roughly 6 mb/d in normal conditions. The shock is therefore increasingly affecting physical export infrastructure, not just prices, while the IEA now expects high energy costs to destroy 2.5 mb/d of global oil demand in 2026 and normalization of Middle East flows to extend into 2027.

At the same time, the first credible diplomatic opening on Hormuz since the conflict began has created a genuine two-sided energy binary. Oman is preparing a Monday meeting involving Iran, Iraq and other Gulf coastal states to discuss regional security and a temporary safe shipping route through Hormuz, with Iran saying negotiations are in their final stages. Bahrain has declined to participate. A workable agreement could represent the first material de-escalation in months and reverse part of the oil shock quickly; failure, or another military incident, would reinforce the risk that disruption to regional energy flows persists.

US inflation became more problematic because the acceleration in core prices cannot be explained by energy alone. Coming after the prior week’s strong August payroll report (+162k vs +55k expected; unemployment 4.1%), headline CPI accelerated to 0.40% MoM and remained at 3.4% YoY, while core CPI increased 0.29% MoM versus 0.20% expected. More importantly, core services excluding shelter jumped to 0.51% MoM from 0.19%, while shelter remained firm but was not the source of the upside surprise. Producer prices rose 0.4% MoM and 5.4% YoY. Higher energy costs are therefore arriving alongside renewed domestic services inflation rather than replacing it. Household confidence is already weakening, with preliminary University of Michigan sentiment falling to 47.8 from 51.7, materially below the 51.0 consensus.

Forward indicators still point to expansion, but increasingly through services rather than uniformly across the economy. US S&P Global composite PMI stood at 56.0 in August, with services at 56.5 and manufacturing at 53.9. ISM services new orders accelerated to 60.9 from 57.2, while manufacturing new orders slowed to 53.7 from 56.7, remaining expansionary but signaling softer goods demand at the margin. Manufacturing PMIs remained above 50 across the US, Eurozone, Japan, UK and China, with sequential improvement in the Eurozone and China. The global cycle therefore does not yet resemble a broad demand contraction despite the deterioration in the energy backdrop.

Europe also continues to absorb the shock better than expected, although national divergences remain significant. Eurozone Q2 GDP was revised to 0.6% QoQ and 1.2% YoY, above expectations of 0.4% and 1.0%, while manufacturing PMI improved to 52.7 and September Sentix confidence rose to 5.1 versus 1.7 expected. Germany remained uneven: factory orders surged 2.5% MoM against 0.3% expected, but industrial production fell 1.1% versus expectations for a 0.2% increase. French industrial production declined 0.4%, while Italy rose 0.7% and UK manufacturing output increased 0.9%. France remains the principal fiscal weak point, with the government acknowledging that the 2026 deficit will exceed 5% of GDP.

China’s established split between strong external activity and weak domestic demand persisted, but this week’s trade and survey data showed continued support from manufacturing. August exports increased 25.0% YoY and imports 28.2%, taking the cumulative trade surplus toward $806bn, while Caixin manufacturing improved to 51.5 and the composite reached 52.1. CPI remained subdued at 0.8% YoY, but PPI accelerated to 3.8%, illustrating the growing tension between higher upstream input costs and still-soft domestic pricing power. Beijing continues to favor implementation of existing infrastructure and local-government financing measures rather than a substantially larger stimulus package. China’s export strength also stands against a weakening global trade backdrop, with merchandise trade volume growth projected to slow to 1.9% in 2026 from 4.6% in 2025 as tariffs, policy uncertainty and the unwind of pre-tariff front-loading weigh on volumes.

Japan is seeing clearer imported-cost pressure even as manufacturing indicators remain strong. Q2 GDP was confirmed at 0.4% QoQ but only 1.4% annualized, below expectations, while producer inflation accelerated to 7.6% YoY and manufacturing PMI rose to 54.9. Machine-tool orders increased 64.7% YoY, highlighting continued industrial strength despite worsening terms of trade. South Korea remained comparatively resilient, with Q2 growth confirmed at 3.7% YoY and unemployment declining to 2.7%.

The macro tension is now clear: resilient activity is colliding with a worsening supply shock and broader US inflation pressure. The coming week turns on whether diplomacy can stabilize energy flows before higher costs transmit further into inflation, margins and household demand.

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Rates

The week was a pronounced bear flattening driven by Fed repricing rather than a long-end fiscal shock. The 2Y rose 25.9 bps to 4.628%, the 5Y 23.7 bps to 4.784%, the 10Y 18.5 bps to 4.969% and the 30Y 10.9 bps to 5.355%. The front end therefore moved more than twice as much as the long bond, flattening 2s10s by 7.4 bps to +34.2 bps and 5s30s by 12.8 bps to +57.2 bps. The probability of a 25 bp September Fed hike rose from roughly 58% after the prior Friday’s payroll report to around 85% by this Friday. The curve move therefore reflected a materially higher expected near-term policy path rather than an outright loss of confidence in the long end.

The decisive signal was higher real yields, not materially higher inflation compensation. Headline CPI rose 0.40% MoM and 3.4% YoY, while core CPI increased 0.29% against a 0.20% consensus and core services ex-shelter accelerated to 0.51% MoM from 0.19%. PPI had already reinforced the inflation signal, with final demand at 5.4% YoY. Yet 5Y real yields rose 21.4 bps to 2.37% and 10Y real yields 16.6 bps to 2.60%, while 5Y and 10Y breakevens increased only 2.7 and 2.0 bps, respectively. Roughly 90% of the nominal selloff therefore came through real rates, consistent with investors expecting the Fed to respond to stronger inflation rather than allowing medium-term expectations to de-anchor.

Bessent’s expanded buyback showed that Treasury can influence liquidity and duration distribution, but not the outright level of yields. Treasury raised the maximum Sep. 10 buyback in the 10–20Y sector to $6bn, triple the previous $2bn level, but below the $7–10bn range investors had increasingly positioned for. The announcement itself pushed the 10Y from roughly 4.81% to 4.84%; Treasury subsequently accepted only $5.187bn of the $10.49bn offered, below the $6bn ceiling, and the 10Y extended its selloff before ending the week at 4.97%. The operational lesson is clear: buybacks can improve market functioning and alter curve structure, but they cannot sustainably offset inflation, Fed repricing or the underlying financing requirement.

Despite the selloff, there is still no evidence of a Treasury buyers’ strike. The Sep. 9 10Y auction showed 79.2% indirect participation, 16.5% direct and only 4.3% left with primary dealers, indicating unusually strong absorption at elevated yields. Bessent subsequently highlighted the week’s auctions as evidence that the Treasury market remained in “very good shape.” Corporate markets sent a similar signal, with more than $60bn of U.S. high-grade issuance absorbed early in the week and deals generally multiple-times subscribed. Structural supply and fiscal concerns remain, but current yields are attracting capital; the market is demanding a higher clearing yield, not refusing to fund issuance.

The global move reinforces that this was a synchronized real-rate repricing rather than a uniquely U.S. Treasury problem. Germany’s 10Y Bund rose 16.6 bps to 3.504%, the UK 10Y gilt 21.0 bps to 5.343% and the Japanese 10Y JGB 6.9 bps to 2.987%. The ECB unanimously raised its deposit rate 25 bps to 2.50%, reinforcing the broader tightening impulse across developed markets. The Bund move was almost identical to the 16.6 bp increase in U.S. 10Y real yields, while gilts underperformed further on domestic fiscal concerns. Japan remained comparatively contained ahead of the BoJ decision next week.

For positioning, the risk remains concentrated in the front end and belly, while the long end is already drawing support from yield-sensitive demand. The 2Y and 5Y absorbed the largest part of the weekly repricing as the market moved toward a September hike, whereas the 30Y sold off materially less and auctions remained well supported. A sustained Treasury rally still requires softer underlying inflation, weaker growth sufficient to reverse the Fed path, or lower duration supply. Until one of those changes, technical support from buybacks and strong auctions can stabilize market functioning but is unlikely to drive a durable decline in yields.

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Cerdit

Credit spreads remained remarkably resilient to a sharp rates repricing, but higher Treasury yields still produced negative total returns. US IG and HY OAS both tightened 2bp during the week, to 78bp and 265bp respectively, yet IG returned −0.93% and HY −0.54%. August inflation surprised to the upside and pushed markets toward pricing a September Fed hike, while rates volatility rose sharply. Credit therefore continues to absorb the rates shock unusually well, supported by attractive all-in yields, but the resilience increasingly depends on Treasury volatility remaining contained.

Headline stability is masking a pronounced deterioration at the weakest end of high yield. BB and B spreads changed little, while the Bloomberg CCC cohort widened 24bp to 1,233bp, taking the gap versus BB credit above 1,000bp. Importantly, this has not yet developed into a broad default cycle: defaults remain contained and stress is concentrated disproportionately in weaker technology and software borrowers. The widening dispersion therefore reinforces the case for security selection rather than signaling generalized deterioration in corporate credit.

Heavy primary supply continues to clear, providing one of the strongest indications that underlying demand for high-quality credit remains deep. US IG issuance reached $73.5bn during the week and $81.9bn for September to date, already absorbing a meaningful portion of the expected monthly calendar without sustained pressure on secondary spreads. HY issuance was also active. Investors are becoming more discriminating on pricing, but the ability of markets to absorb this volume against a backdrop of rising Treasury yields remains an important technical support.

Fund flows show that the all-in-yield bid is increasingly concentrated in investment grade rather than extending uniformly across riskier credit. IG attracted inflows during the week, while HY experienced approximately $1.6bn of outflows, driven largely by ETFs; leveraged-loan flows were broadly flat. This divergence suggests investors still want credit income, but are increasingly expressing that demand through higher-quality assets rather than reaching for spread at the lower end of the market.

AI-related borrowing is creating increasingly differentiated opportunities within investment grade. The highest-quality hyperscalers continue to trade competitively at intermediate maturities, while longer-dated bonds carry materially larger premiums, reflecting duration and the technical burden of extraordinary funding requirements rather than a broad deterioration in credit quality. Oracle provided the clearest case study this week: strong cloud growth pushed its 10Y bond spread roughly 9bp tighter after earnings, but exceptionally high capital expenditure and negative free cash flow kept longer-term balance-sheet concerns intact. The market is increasingly distinguishing between strong AI-driven earnings growth and the credit cost required to finance it.

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