But the stronger-than-expected US CPI figures reversed the positive mood, fuelling hawkish Federal Reserve (Fed) expectations, pushing US yields sharply higher and equities lower. The US 2-year yield, which best captures expectations for Fed rates, rose more than 20bp as the figures cemented expectations that the Federal Reserve (Fed) will raise rates when it meets in December. Comments from the Fed’s Waller (saying that he would support a rate hike in December and that a 50bp hike should be considered if inflation disappointed) and Logan (highlighting the need for at least two more 25bp hikes at a quicker pace) helped pushing rate expectations into a more hawkish direction.

According to pricing in Fed funds futures, a Fed rate hike is priced as a certainty for December, with a nearly 13% chance of a 50bp hike. In summary, the market discussion is no longer about whether the Fed will hike rates this December, but by how much.

How does that translate into equity, bond and FX pricing?

For bonds, rate hike expectations are pushing the shorter end of the US yield curve up more sharply than the longer end, hence narrowing the US 2–10y spread: the latter has now narrowed more than 6bp to below 26bp. An inversion—when the spread turns negative—is often read as a signal of heightened recession risk, reflecting expectations that rate hikes today to fight inflation could slow economic growth and eventually lead to lower rates. As such, it’s important to monitor how the curve behaves as hawkish Fed expectations gain ground again. Favouring longer duration could make sense if growth concerns eventually outweigh inflation risks.

For equities, higher yields put downward pressure on valuations. But there are two opposing forces in US and European stock markets today. While upward pressure on yields—and borrowing costs—raises questions about equity valuations, earnings are coming in surprisingly strong.

Moreover, earnings released by companies on both sides of the Atlantic suggest that earnings strength broadened from tech to non-tech sectors in Q3, despite elevated energy prices and rising yields. That surprising earnings resilience and widening breadth are supportive of the equity outlook.

Inside equities: energy companies, banks, industrials and healthcare companies have delivered strong quarterly results, while technology companies’ rising spending has overshadowed their strong earnings growth. Here, valuation adjustments could make matters worse. In case you missed it, some technology companies’ reported profits have also benefited from paper gains on their investments in AI companies. If those investment values fall and losses are recognised, they would weigh on reported earnings.

In FX, the stronger-than-expected US CPI boosted hawkish Fed expectations, which in turn fuelled appetite for the US dollar. But as we discussed earlier, the dollar’s outlook could weaken if expectations of slower AI expansion and more constrained government spending following last week’s Democratic sweep weigh on US growth prospects and real yields. As such, I believe the direction of US real yields, particularly relative to those elsewhere, will help determine whether the US dollar has scope to gain further ground against other major currencies, also tempted to raise rates to fight inflation.

Overall, the AI trade remains in limbo and the latter complicates the US dollar’s upward trajectory. Deteriorating sentiment towards all things tech supports rotation, but the rotation trade could run into the barrier of elevated inflation and expectations of higher rates. If overall risk appetite weakens, longer-term government bonds and equity indices with low exposure to technology and higher exposure to defensive companies could outperform the rest. European indices with a defensive bias, including the healthcare- and consumer-staples-heavy SMI, could therefore be on a stronger footing than their wobbly US peers.