Stress in sovereign bond markets weighs on FX.

Sovereign debt focus hits risk sentiment and currencies
The US dollar ended Friday and the traditional pre-Labor Day end of summer on a weak note, but has suddenly perked up as the post-holiday week got under way yesterday in the US. It’s hard not to link the USD strength with weak global risk sentiment yesterday, but what is the source of concern? As discussed on yesterday’s Saxo Market Call podcast, some of sentiment dip may be down to jitters in the AI space after a stumble in AI names late last week, but that doesn’t help to explain the very weak action across equity markets in Europe yesterday.

It’s more likely that the main source of concern is the ongoing stress in global bond markets as the longest bond yields continue to hit new cycle highs in several countries. Germany’s and France’s 30-year benchmarks hit new cycle and decade+ highs, even if the Germany-France 10-year yield spread remains stable, if still nervously elevated at 80 basis points, ahead of confidence vote next Monday in the French parliament.

The long 30-year Gilt in the UK hit a new high since all the way back in 1998 yesterday, trading above 5.70%, which is helping to drive mounting urgency in the Starmer-led government to get the fiscal house in order as he is scrambling to put together a team ahead of the fall budget statement in October. If this team and Chancellor Reeves come up with a combination of new taxation and austerity, it is far from sure that sterling will breathe any sigh of relief as weaker UK growth on these policies could fail to improve the deficit trajectory. The situation is untenable and sterling exchange rates are picking up on the unease, if far less than perhaps they should.

Likewise, despite our constant reminders that Japan is well placed to deal with any pressure that develops on its sovereign bond markets, given the very long maturity profile of Japanese debt and its best-in-class net international investment position, the lack of new policy moves to address the situation and low policy rates and traditional market correlations mean that the market knee-jerks to sell the JPY when long yields are on the rise as they are now – as the US 30-year benchmark teases 5.00% (high was 5.18% in late 2023), while the 30-year JGB benchmark posted a new all-time high since its introduction in 2000 at 3.30% overnight, up a chunky seven basis points in the session overnight.

Elsewhere, the resurgence of the Swedish krona and Norwegian krone could be the flipside of all of this, as the two countries have cheap currencies and pristine sovereign balance sheets by any measure.

For now, it is hard to swallow the idea that the US dollar will prove a safe haven if fiscal stability  and pressure on bond markets are the focus, but in times of unease, the chief priority is nearly always simply liquidity, and that’s where the US dollar always shines. For its part, the euro looks far too expensive if we are set for a major bout of pressure on French sovereign debt after the September 8 vote – a key date for the outlook for not only EURUSD, but also USDJPY.

Chart: GBPUSD
GBPUSD came unglued yesterday, perhaps in part on the renewed market focus on the pressure on sovereign debt, as the long 30-year UK Gilt hit a new post-1998 high yesterday. So far, the move hasn’t broken anything in the chart, but sets things on edge for a possible test lower. If that test reaches the 1.3140 area, it would complete a rough head-and-shoulders formation and suggest the risk of much lower levels toward 1.2500 and beyond. A move of such magnitude might require a fresh and significant attack on UK gilts, something a-la-Truss, although the Bank of England would likely be far quicker to keep order in the gilt market this time around, even if this comes at the expense of sterling weakening.