Weekly Market Update: AI Sell-Off Sparks Bond Rally as Growth Concerns Mount (19 October 2026)

“All people are born alike - except Republicans and Democrats.”

- Groucho Marx

Cartoon of the Week

Source: www.hedgeye.com

Funds Snapshot

Movers & Shakers (week ending 2 October):

Stocks (ASX 200 ↑ 1.03%, S&P 500 ↓ 1.95%, NASDAQ ↓ 4.48%)

Bond Yields (ACGB3Y 4.84%, ↓ 5 bps / ACGB10Y 5.23%, ↓ 10 bps)

Bond Curves (A$ 3s10s +39 bps, ↓ 5 bps)

Credit Spreads (Major Bank 5Y Senior +70 bps, ↑ 1 bp / Tier 2 +134 bps, ↑ 1 bp)

Policy (RBA Cash 4.60%, ↔ / US Fed Funds 3.75–4.00%, ↔)

Oil (Brent US$109.86/bbl, ↑ 4.91%)

Gold (US$4,166/oz, ↓ 0.68%)

Market Overview

Tthe AI trade blinks, and bonds remember what they’re for.

• Australia’s labour market cracked, and the November hike was priced out, then partly back in.  Employment fell ↓39,300 in September against expectations of a 20,000 rise, and unemployment climbed to 4.7%, already above the 4.5% the RBA had forecast for December.  Full-time jobs rose ↑34,400, with the fall driven by part-time roles, and the ABS cautioned that a survey method change may be distorting the seasonally adjusted data.  The trend, however, is clear: trend employment growth has slowed to around 16,000 a month from 32,000 three months ago, and underemployment rose to 6.3%.  Three- and ten-year yields fell ↓11 bps on the release and a November hike was priced out almost entirely, before the odds recovered to around 27% by Friday.

• Business told the same story, with a sting in the tail.  NAB business confidence fell to −13 from −9, while the survey’s employment index hit a five-year low.  Yet purchase costs remain well above average and capacity utilisation is above average in five of eight industries: weak confidence alongside elevated costs is the RBA’s dilemma in miniature.  Tuesday’s RBA minutes judged that inflation risks had materialised, but also signalled that returning inflation to target amid persistent supply shocks may mean accepting slower growth in employment.  In plain terms, the Board will tolerate some rise in unemployment.  The IMF projects Australia’s unemployment rate will average 4.7% next year, the largest rise among advanced economies, while inflation stays above target at 3.1%.  On the first count, we have already arrived.

• In the US, inflation surprised to the upside again, and is broadening.  September CPI rose 0.6%, lifting annual inflation to 3.7% (3.6% expected), with core at 2.6% (2.5% expected).  Producer prices rose ↑6.3% over the year, the fastest in more than four years, led by a ↑10.8% monthly jump in energy.  Transport costs are the channel through which oil feeds into the price of almost every good.  Real hourly earnings fell 0.7% over the year, and while retail sales beat expectations (↑0.8%), the control group rose only 0.1%, with petrol spending masking softer discretionary demand.  New York Fed President Williams sees one more hike this year but none in 2027, and Governor Waller noted that higher long yields are already doing some of the Fed’s work.  Markets price roughly a one-in-three chance of a hike on 28 October, with December close to fully priced.

• China answered last week’s question: yes, it is adding to global goods inflation.  Chinese producer prices rose 5.0% over the year, well above the 4.4% expected, while exports surged ↑36.3% against ↑25.7% expected.  With consumer prices up only 0.9%, China is exporting price pressure rather than generating domestic demand.  Europe confirmed inflation at 3.8% while industrial production fell ↓0.5%, and the EU is reportedly preparing tools to restrict Chinese imports.  Trade friction of this kind tends to raise costs, not lower them.

• The dominant narrative: the AI trade met its first serious test, and bonds acted as a safe haven.  Wednesday’s hot CPI triggered the S&P 500’s largest fall since July, ending its longest run without a 1% decline in more than six years, and the semiconductor index fell ↓11.6% over about a week.  The worry is not whether AI demand is real, but whether the infrastructure build-out can earn an adequate return, crystallised by AI cloud provider CoreWeave, whose bonds fell to distressed levels by Friday.  Importantly, Treasuries rallied despite hotter inflation, the US dollar rose to its highest since May 2025 and the VIX rose to 19.99.  Last week we noted that when bonds and equities disagree this sharply, bonds have more often been right; this week equities moved part of the way toward the bond market’s view.  For defensive portfolios, the key observation is that at yields above 5%, high-quality bonds once again have room to rally when growth fears dominate.

• Oil rose, gold fell, and the Australian dollar weakened.  Brent rose ↑4.91% to US$109.86 per barrel, touching US$110 on Friday, and is ↑80% over twelve months.  With Russian strikes on Ukrainian energy infrastructure and ongoing risks to Middle East shipping, the supply risk premium remains firmly in place. Gold eased ↓0.68% to US$4,166 despite the risk-off tone, as a stronger dollar and rising rate expectations raised the opportunity cost of holding an asset that pays no income.  The Australian dollar slipped ↓0.53% to US69.46 cents. Because oil is priced in US dollars, a weaker currency amplifies the fuel price shock at home, an unwelcome complication for the RBA.

Equity Markets

A rotation, not yet a rout.

• Australian equities rose, but the leadership was defensive.  The ASX 200 rose ↑1.03%, leaving it ↑1.27% over the month but ↓2.89% over twelve months.  Eight of eleven sectors gained, yet the leaders tell a cautious story: Utilities (↑4.47%), Health Care (↑3.88%) and Consumer Staples (↑3.35%) led, the classic pattern when investors want earnings that hold up in a slowdown.  Financials (↑3.20%) and Consumer Discretionary (↑2.15%) were supported by lower bond yields and a reduced risk of another RBA hike after the jobs report, while Energy (↑1.31%) tracked oil higher.  At the other end, Information Technology (↓1.28%) followed the global AI sell-off, Materials (↓2.31%) were weighed down by weaker precious metals prices and the slide in Chinese equities, and Real Estate (↓1.73%) fell despite the rally in bonds.  The local market’s small weighting to technology was an advantage.  On 18.4x forward earnings, the 5.45% earnings yield now sits 22 bps above the ten-year bond, up from 16 bps, improved this time by falling yields. The 3.53% dividend yield remains 107 bps below cash before franking. A softer labour market cuts both ways: it lowers the risk of another hike, but raises the risk to consumer-facing earnings and, over time, bank bad debts.

• US equities: a recalibration of AI expectations, not yet a broad sell-off.  The S&P 500 fell ↓1.95% and the NASDAQ ↓4.48%.  Beneath the surface, the picture was less alarming: on Thursday the equal-weighted S&P 500 rose ↑1.4% as investors rotated into the broader market.  Early bank earnings were mixed.  The deeper issue is financing: bond issuance by hyperscalers and digital infrastructure companies has reached around US$500 billion this year, so the AI build-out is increasingly debt-funded just as borrowing costs rise, linking equity risk to credit markets and long-term yields.  The S&P 500 earnings yield now sits 36 bps below the ten-year Treasury, narrower than last week’s 61 bps, and the NASDAQ 173 bps below.  Valuations have improved, but still require third-quarter profits to deliver the ~25% growth expected.

Fixed Income & Credit

The jobs report does the talking.

• Australian government bonds rallied, led by the long end.  Three-year yields fell ↓5 bps to 4.84%, five-year ↓8 bps to 4.91% and ten-year ↓10 bps to 5.23%, flattening the three-to-ten-year curve by 5 bps to 39 bps. The long end was supported by the global Treasury rally, while the front end stayed anchored by inflation risk ahead of the September-quarter CPI.  Three-year yields sit 24 bps above cash, and the implied peak cash rate eased to around 4.84% from 4.88%, consistent with roughly one more hike.  The rally does not settle the structural debate: some strategists argue record government issuance, sticky inflation and AI-related borrowing could take ten-year yields toward 5.75–6.00% in a scenario where the RBA hikes further.

• The RBA: the labour market has bought time, not certainty.   A pause at 4.60% on 3 November looks more likely, and NAB now expects a hold, though ANZ still sees a hike as more likely than not, citing capacity pressures, higher energy prices and a higher starting point for inflation.  The decisive input is the September-quarter CPI on 28 October.  Given the Board’s stated tolerance for slower employment growth, one weak jobs report will not, on its own, prevent a hike if inflation is strong.  A pause remains our central case and a second hike a meaningful minority scenario, but the balance has shifted modestly toward patience.

• US Treasuries rallied on fear, not on inflation relief.   Two-year yields fell ↓8 bps to 4.71% and ten-year ↓17 bps to 5.07%, flattening the curve to around 36 bps. The rally came despite hotter CPI and PPI data: a flight to quality from AI-led equity weakness, not a judgement that inflation is easing.  The ten-year is still ↑110 bps over the year, and if equities stabilise and attention returns to inflation and government borrowing, much of this week’s rally could reverse.  Offshore long yields continue to set the tone for Australian ten-year bonds.

• Credit: modest indigestion, not stress.  Major bank senior spreads widened ↑1 bp to 70 bps and Tier 2 ↑1 bp to 134 bps, both still inside their one-year averages (73 bps and 137 bps), while the floating rate credit index was steady at 64.0 bps.  Dealers reported selling in two-to-three-year major bank paper ahead of new supply, while ETFs deployed cash into Tier 2.  Police Bank (BBB+) launched a three-year senior deal guided around 120 bps, a modest concession to fair value that continues the trend of smaller lenders paying more relative to the majors.  The deal priced at 117 bps.  The slump in CoreWeave’s bonds is a reminder that AI is now a credit story too.  Domestic bank and securitised credit has little direct exposure, but a broader repricing of offshore corporate credit would not leave Australian spreads untouched.

• For income investors, both sides of the defensive portfolio did their job.  Floating rate credit yields approximately 5.40% all-in, major bank senior approximately 5.89% and Tier 2 approximately 6.53%. Floating rate credit pays roughly 80 bps above cash and 187 bps above the ASX 200 dividend yield, with far less price sensitivity than ten-year bonds.  This week, floating rate credit kept delivering income while government bonds delivered capital gains as equities fell.  A softer labour market strengthens the case for some short-to-medium duration as ballast, but we would not chase long bonds after one week, as global term premium remains the dominant force at the long end.  If Q3 inflation forces a hike, floating coupons reset higher; if the labour market keeps softening, short-to-medium duration benefits.

Outlook

Two weeks to the RBA, and two very different signals.

• The central case.  Australian growth is slowing more clearly, with the labour market now confirming what surveys have been signalling. Inflation is still energy-led, but signs of broadening are accumulating, from US core prices to Chinese producer prices.  A pause at 4.60% remains the RBA’s most likely path, with a further hike a meaningful minority scenario that hinges on Q3 CPI.  Rate cuts are not a realistic near-term scenario while oil sits near US$110, though a sustained deterioration in employment would bring that debate forward into 2027.

• Central banks.  The Fed meets on 28 October with markets leaning toward a pause and a December hike. The ECB faces inflation of 3.8% alongside contracting industrial output.  Policy rates are close to their peaks globally, but long-term yields will depend as much on government borrowing and AI-related debt issuance as on central banks.

• Key risks.  First, that a strong Q3 CPI forces the RBA to tighten into a weakening labour market, with consequences for house prices, mortgage arrears and bank subordinated debt.  Second, that the AI correction broadens into credit markets, widening global spreads.  Third, oil near US$110 continuing to feed into core goods prices.  Fourth, that rising term premium pushes long yields higher even as growth slows, the stagflationary mix in which bonds and equities fall together.

• Key opportunities.  Floating rate credit at around 5.4% remains the core income opportunity, with built-in protection if rates rise further.  Short-to-medium duration has become more attractive as the labour market softens.  Tier 2 at 134 bps and AAA senior RMBS at around 103 bps over bank bills offer reasonable compensation, and new-issue concessions from smaller lenders provide selective entry points.  Ten-year bonds above 5.2% demonstrated their diversification value this week, though we prefer to add on weakness rather than chase.

• What would change the narrative?  In Australia, Friday’s flash PMIs (composite previously 51.3) will show whether activity is following employment lower ahead of Q3 CPI.  China’s Q3 GDP (consensus 4.4%) and retail sales (0.5%) will test whether domestic demand can absorb an export boom. In the US, flash PMIs (composite consensus 57.4 from 58.4) and the final University of Michigan survey, including one-year inflation expectations (previously 4.7%), will show whether inflation is feeding household psychology. Beyond the data, the next wave of US earnings, and above all any change in AI spending plans, will decide whether this week’s rotation remains orderly.  A break in oil above recent highs would reinforce the inflation narrative; a credible de-escalation would ease it.