The long, hot summer is over and this week has a distinctly ‘back to school’ feel about it, with holidays over, suitcases back in the loft, cooler weather and the dreaded new school uniform/shoes shopping trip completed.
For financial markets, August saw a continuation of recent themes – strong corporate earnings, heightened geopolitical risks around the Middle East and continuing debate over the path for inflation and interest rates.
Many of these themes are interlinked – increasing tensions in the Middle East are pushing up commodity prices again, leading to inflation concerns, which in turn are increasing expectations around interest rate hikes. The prospect of higher interest rates is weighing on bond markets, with yields pushing upwards. History shows that financial markets often hit an air pocket when the Federal Reserve (Fed) raises rates, so is it time to return to your seats and fasten your seatbelts?
Recent weeks have seen the situation in the Middle East deteriorate as both the US and Iran move away from what appeared to be a framework for a peace deal as agreed under the memorandum of understanding signed back in June. Since then, both the US and Iran have claimed control of the Strait of Hormuz, and visible shipping transiting the Strait remains extremely low. Thankfully the number of ‘dark transits’ along with ships paying a fee to Iran for passage has meant that a much higher amount of oil is now leaving the region. Goldman Sachs estimated last week that oil exports from the region have recovered to about two-thirds of pre-war levels, either through the Strait of Hormuz or via pipelines being used at maximum capacity. This is good news for oil markets, though Brent Crude remains elevated and pricing indicates that stresses remain in refined products, such as diesel, and across Liquified Natural Gas markets where there are no pipelines to replace shipping routes, and no ‘shuttle’ system with smaller tankers making dark transits of Hormuz before transferring crude oil to larger vessels.
In terms of the politics, both sides appear content to play the long game, with no negotiations taking place, and the US trying to squeeze Iran further by means of wider economic sanctions. This week has seen a return to kinetic warfare for the first time since July, with the US attacking Iran’s anti-ship capabilities and Iran retaliating by attacking US regional bases. Unfortunately, the conflict now appears back on a path of escalation, and any form of resolution before the US mid-term elections now appears unlikely.
The prospect of higher commodity prices continues to weigh on the inflation outlook, particularly in the US, where Fed Chair Kevin Warsh reiterated his discomfort with inflation being above target in comments last week. Warsh made clear that his main focus was PCE inflation, currently 3.7%. The last time PCE inflation was below the Fed’s 2% target was February 2021. The hawkish commentary from Warsh has increased expectations that the Fed will raise interest rates when they meet later this month.
Higher interest rates mean higher bond yields and despite intervention from the US Treasury, long bond yields have continued to climb, driven by a strong economic backdrop, higher inflation risks, and the prospect of the Fed tightening policy. The US Treasury announced it would increase its buyback program for longer dated US bonds in the middle of August, but yields surpassed the levels seen before the announcement earlier this week. The size of the asset purchases may well be increased in the future – the Treasury has made clear through the buyback scheme announcement that it is not comfortable with bond yields at these levels, as the US government seeks to reduce long-term borrowing costs. However, with the US economy in robust health, driven by huge levels of AI-related capex, and persistent inflation pressures, bonds will remain under pressure, not least when a hawkish Fed under Kevin Warsh has made clear rate hikes are likely, unless economic data suddenly deteriorates between now and the next Fed meeting which is less than a fortnight away.
The US government could help itself by reducing the phenomenal pace of government spending, with the US national debt passing the milestone of $40 trillion last month, up from ‘only’ $20 trillion a decade ago. The cost of servicing such borrowing, not least when interest rates are moving higher, is a huge burden on the public finances. This last point is not just a US problem, with governments across developed markets having piled on the debt since the Global Financial Crisis. The UK budget, set for 28 October, will highlight the continuing struggles for the UK government – under any leader – to balance the books whilst striving to boost mediocre economic growth. We have seen over recent years, in the UK, France and Japan for example, that political uncertainty brings a renewed focus on what appear to be unsustainable debt trajectories. The US could be next in the spotlight.
It will likely be a busy autumn politically, both in the UK as we lead up to the Budget, and in the US as the mid-term elections in early November bring the prospect of Democrats taking control of the House of Representatives, and more scrutiny and pushback for the Trump administration. We will also see key elections in Brazil, Sweden, Israel and New Zealand, and the trade ‘truce’ between the US and China is due to expire in November.
Financial markets have proven very resilient over the course of 2026 despite plenty of headwinds. These have been offset by a positive economic backdrop, and strong corporate earnings. Both of these factors remain supportive. However, we also need to note that inflation and interest rate risks are building, and higher bond yields have caused turbulence across financial markets in the past. If the Iran situation can move towards de-escalation and resolution, then these concerns will diminish, but with plenty of headline risks over the coming weeks influencing market dynamics both risks and opportunities are likely to emerge.
