Yield Hikes, Normalization, and Macro Trends Dominate Market Narrative

Global markets were shaken on Monday by a fresh escalation of hostilities between the United States and Iran, with U.S. strikes against IRGC targets on Larak Island in the Strait of Hormuz, and Iranian retaliatory measures against the United Arab Emirates and Jordan.

The same day, Fed Chair Kevin Warsh delivered a hawkish speech at Jackson Hole, reaffirming the 2% inflation target and stating that 'there is work left to do.'

As an immediate result, the probability of a Fed rate hike in September jumped from 36% to 67%, with U.S. Treasury yields reaching annual highs approaching 4.8%. Japanese sovereign debt (with JGBs near 3%) and German debt (Bunds at 3.3%) were also affected.

Despite concerns over the rising national debt, which is nearing $40 trillion, analysts argue that the historical correlation between debt-to-GDP ratio and real rates (TIPS) is negative due to the government's past practice of increasing spending during recessions. The Congressional Budget Office (CBO) analysis projects a less-than-optimistic fiscal outlook, but nominal economic growth (according to the New York Fed's model) remains strong, exceeding the 10-year bond yield.

The normalization of growth, inflation, and rate trends is seen as the primary driver behind the rise in yields. The past decade's disinflationary dynamics, household and corporate balance sheet deleveraging, and below-potential growth led major central banks to adopt zero interest rate policies.

However, over the past two years, we have witnessed a macro normalization, with inflation rates slightly above the comfort zone and more robust GDP growth. As a result, 10-year real interest rates in the United States have returned to the range where they fluctuated in the mid-2000s, still well below the levels reached in the 1990s.

Households and businesses are less sensitive to rate hikes than in the previous decade, with their balance sheets having been repaired since then. Household debt as a percentage of GDP hovered around 100% between 2008 and 2009 and today stands at 64.85%, levels not seen since 1997.