Hotter inflation, lower yields

Summary

Last week in markets

Markets ended the week lower as investors weighed stronger inflation, resilient economic activity and growing concerns about the financing costs of artificial intelligence (AI) investment. The S&P 500 Total Return Index declined 2.03%, falling from 17,523.23 on October 9 to 17,168.02 on October 16.

September's Consumer Price Index (CPI) rose 0.6% month over month and 3.7% year over year, while core CPI increased 0.3%. Producer prices rose more sharply, with the Producer Price Index (PPI) increasing 1.3% for the month and 6.3% annually. Retail sales advanced 0.8%, and industrial production rose 0.7%, reinforcing evidence of sustained demand. Technology and semiconductor stocks led the market decline as investors reassessed the sustainability and financing costs of aggressive AI capital spending.

Despite stronger inflation data, Treasury yields declined. The 10-year Treasury yield ended the week at 5.09%, down 15 basis points from 5.24% the previous Friday. The equity selloff and concerns about the effects of persistently high borrowing costs outweighed the inflation surprise, increasing demand for Treasuries.

Energy prices added to inflation concerns. Brent crude traded near $105 to $106 per barrel through Thursday before surging Friday to settle at $109.86, an increase of approximately 4.9% for the week. Renewed attacks on Russian energy infrastructure and continued disruptions around the Strait of Hormuz heightened supply concerns.

Together, these developments present a challenging environment for policymakers. Higher energy prices and stronger inflation readings point to persistent price pressures, while weaker market sentiment and increased demand for longer-duration Treasuries suggest growing concern about the economic effects of elevated borrowing costs.

The week ahead

The coming week will provide important signals about how elevated borrowing costs are affecting interest rate-sensitive sectors, labor market conditions, and inflation expectations.

Today, the Bank of Canada will release its Business Outlook Survey and consumer expectations survey, providing insight into inflation expectations and business investment plans.

Tuesday brings September U.S. housing starts, building permits and pending home sales. With mortgage rates elevated and the 10-year Treasury yield above 5%, these reports will help assess whether financing costs are weighing on construction, housing transactions, and household demand. Weaker readings would support the recent Treasury rally, while continued resilience could suggest that monetary policy remains insufficiently restrictive.

Thursday's initial jobless claims and Leading Economic Index will offer further evidence of whether the labor market and broader economy are losing momentum.

On Friday, flash purchasing managers' index (PMI) surveys for the United States, euro area, United Kingdom, and Japan will provide a timely view of economic output, employment, and input costs. The final University of Michigan consumer sentiment survey will also be important following an increase in preliminary inflation expectations. Year-ahead expectations rose to 4.7%, while long-run expectations reached 3.5%. Further increases would complicate the Federal Reserve's efforts to keep inflation expectations anchored.

The Federal Reserve will remain in its communications blackout ahead of its October 27-28 policy meeting. With Fed officials unable to provide additional guidance, incoming economic data, oil prices, and market-based expectations will play a central role in shaping the policy outlook.

Geopolitical developments will remain another important variable. Further disruptions through the Strait of Hormuz or additional damage to Russian refining capacity could push Brent crude prices higher, increase inflation compensation and weigh on equity valuations. Conversely, stable energy flows could create room for Treasuries and equities to recover.

The central question for markets is whether inflation pressures will remain elevated as financial conditions weigh more heavily on economic activity. Another oil price shock would intensify that tension, making the balance between inflation risks and slowing growth increasingly difficult for policymakers and investors to navigate.