Weekly Market Update: Sticky Inflation Pushes Rate Expectations Higher as Bond Yields Rise (31 August 2026)

“Originality is the fine art of remembering what you hear but forgetting where you heard it" 

- Laurence J. Peter

Cartoon of the Week

Source: www.hedgeye.com

Funds Snapshot

Movers & Shakers (week ending 14th August):

Stocks (ASX 200 ↑ 0.37%, S&P 500 ↑ 0.49%, NASDAQ ↑ 0.85%)

Bond Yields (ACGB3Y 4.66%, ↑ 9 bps / ACGB10Y 5.10%, ↑ 4 bps)

Bond Curves (A$ 3s10s +44 bps, ↓ 5 bps)

Credit Spreads (Major Bank 5Y Senior +68 bps, ↑ 4 bps / Tier 2 +127 bps, ↔)

Oil (Brent US$89.31/bbl, ↓ 5.38%)

Gold (US$4,455/oz, ↓ 3.21%)

Executive Summary

• Australian inflation refused to fall as expected. July Headline CPI came in at +3.5% YoY against a +3.3% YoY forecast, and the trimmed mean — the RBA’s preferred core measure — held stubbornly at +3.6% YoY, above expectations and above the target band. Household spending accelerated to +7.0% annually against a +5.7% forecast. It doesn’t look like prices are going south anytime soon.

• The front end of the bond market repriced immediately. Three-month BBSW rose 6 bps to a one-year high, three-year government bond yields rose 9 bps, and three-year swap rose 12 bps. Australian and US curves both flattened sharply as markets priced out easing and began pricing tightening risk.

• Equities barely reacted, rising modestly with volatility falling. For income investors, the practical consequence is favourable: floating rate coupons now reset higher, with investment grade floating rate credit yielding approximately 5.15%, for a weighted average credit rating of AA–.

Market Overview

The dominant narrative: The disinflation trade has stalled 

• For much of this year the working assumption in markets has been that inflation was on a slow but reliable path back to target, and that policy rates would eventually follow it down. This week supplied contrary evidence in both Australia and the United States, and the front end of both bond markets responded decisively.

• Headline inflation did fall, from +3.8% YoY to +3.5% YoY. But it fell by less than expected, and the more important number is the trimmed mean at +3.6% YoY — unchanged from the prior month, above the +3.5% YoY forecast, and comfortably above the 2–3% target band.

• The distinction matters, and it is worth explaining plainly. Headline inflation includes volatile items such as fuel and fresh food, which can swing sharply for reasons unrelated to the underlying pressure in an economy. The trimmed mean strips out the largest movers in both directions to reveal the persistent component. Headline inflation improving while the trimmed mean stands still tells you that the improvement is coming from volatile items, not from the underlying inflation problem. The monthly trimmed mean actually accelerated, to +0.5% MoM from +0.3% MoM.

• Household spending explains a great deal of why. Spending rose +7.0% YoY against a +5.7% YoY forecast, with the monthly figure at +1.1% MoM against +0.3% MoM expected. Australian consumers are not behaving like people constrained by a 4.35% cash rate. Demand of that strength gives businesses room to pass on costs, which is precisely the mechanism that keeps core inflation elevated.

• The other side of the Australian ledger: We would be presenting an unbalanced picture if we stopped there, because the business side of the economy delivered genuinely poor numbers in the same week. Private capital expenditure fell 3.6% in the June quarter against an expected +0.8% rise, reversing a +6.9% gain. Construction work done fell 2.1% against an expected +0.4% increase. These are meaningful misses, and they follow last week’s employment report showing a 16K fall in jobs and unemployment rising to 4.5% (albeit still well below post-GFC averages).

• Australia now presents an uncomfortable combination: sticky core inflation and a strong consumer on one side, contracting business investment and a softening labour market on the other. At least, that is what the latest data suggests — with the caveat that capex is a volatile series. Nonetheless, this is closer to a stagflationary configuration than anything we have described in recent months, and it is the least helpful backdrop for a central bank. Policy that addresses the inflation problem worsens the investment problem, and vice versa.

• The RBA’s August Statement had already flagged that “historically weak productivity growth continues to constrain potential growth.” Capital expenditure contracting 3.6% in a quarter does not improve that outlook.

Equity Markets

• A quiet, mildly positive week across developed markets, with the NASDAQ leading at +0.85%. The most striking feature of the week was how little equity markets cared about the data. The VIX fell 0.70 points to 14.43, and every major developed market rose modestly. A meaningful hawkish repricing at the front end of two major bond markets produced almost no equity volatility.

• The more interesting question is why developed equities rose at all. Bond markets spent the week concluding that rates will stay higher for longer. Higher rates ordinarily compress equity valuations. Yet the NASDAQ, the most valuation-sensitive major index at 28.9x forward earnings, led the market higher.

• We can offer two partial explanations. The repricing in bond markets was concentrated at the front end — the US ten-year actually fell ~2 bps and the Australian ten-year rose only 4 bps — and long-dated equity valuations are more sensitive to long yields than short ones. Alternatively, equity investors may be reading the strong household spending and consumption data as supportive of earnings, offsetting the discount rate effect. We flag both as hypotheses.

• The Australian equity risk premium has now compressed for a third consecutive week — from approximately 33 bps to 27 bps, to 18 bps. Australian equities rose modestly while bond yields rose more, and the gap narrowed again.

• Eighteen basis points is the compensation an investor currently receives for accepting the volatility, drawdown risk and earnings uncertainty of the Australian share market instead of holding a government bond. We would characterise that as thin by any historical standard.

• The twelve-month picture reinforces it. The ASX 200 has returned 1.3% in price terms over the past year while cash paid 4.35%. The index yields 3.27% before franking, and on a grossed-up total return basis the twelve-month comparison improves materially, to approximately +5.1%. On price alone, however, an investor who accepted full equity market risk for twelve months was rewarded with a little over one per cent.

• Europe remains the best-positioned major market on valuation grounds at 15.9x forward earnings, a 6.30% earnings yield, and a third consecutive week of improving confidence data alongside inflation expectations converging on target.

Fixed Income & Credit

• Three-month BBSW rose 6 bps to 4.55%, which is its highest level in a year. Its premium over the cash rate widened to 20 bps from 14 bps. This is the single most informative number in this week’s dataset, and it deserves explanation. BBSW is the rate at which Australian banks lend to each other over three months. It sits above the cash rate by an amount that reflects both bank funding conditions and, importantly, market expectations for where the cash rate is heading over that horizon. A 6 bps jump to a one-year high, in a week when the RBA did not meet, is the market attaching greater weight to the possibility that the cash rate goes up rather than down.

• The government bond curve bear-flattened, meaning short yields rose more than long ones. Three-year yields rose 9 bps against the ten-year’s 4 bps, narrowing the three-to-ten year curve to 44 bps from 49 bps.

• The interpretation is straightforward. Yields at the short end are driven primarily by expected policy. Yields at the long end are driven more by expected long-run inflation and growth. A curve that flattens because the short end sold off is a market saying: policy will be tighter than we thought over the next few years, but this does not change our view of the long-run economy. Given a trimmed mean stuck at +3.6% and household spending at +7.0%, that is a coherent conclusion.

• In US Treasuries, the two-year rose 11 bps to 4.34% — essentially its one-year high of 4.35% — while the ten-year fell ~2 bps to 4.72%. The two-to-ten year curve collapsed to 37 bps from 50 bps.

• This is a sharper version of the Australian move, and the divergence between the two ends is instructive. The front end responded to sticky core PCE and an upward revision to Q2 core inflation. The long end responded to collapsing survey data — Chicago PMI at 47.1, Philadelphia non-manufacturing at -10.6 — which speaks to weaker future growth.

• A curve flattening this aggressively reflects a market pricing tighter near-term policy and weaker medium-term growth simultaneously. Historically, that combination has been associated with slowing economies, though we would caution that curve signals have been unreliable in recent cycles and we place limited weight on it.

• Credit spreads widened modestly again, with major bank senior paper the most affected at 4 bps.

• A three-week pattern has now established itself that requires us to revise a view. Major bank senior spreads have moved 63 → 65 → 68 bps over three weeks, widening 5 bps in total. Tier 2 has been unchanged at 127 bps for two of those weeks.

• The consequence is that the subordination premium — the additional spread earned for holding subordinated bank paper rather than senior — has compressed from 64 bps three weeks ago to 59 bps, now below its one-year average of approximately 64 bps.

• In our commentary of 14 August we noted that Tier 2 offered better relative value than senior, on the basis that senior sat exactly at its one-year tight with no cushion while Tier 2 sat 16 bps above its own tight. That relative value gap has now substantially closed, and we are updating the view. Senior has cheapened by 5 bps and now sits 5 bps above its tight. Tier 2 has not moved. Investors are being paid less than the one-year average for accepting subordination risk.

• We would not characterise Tier 2 as poor value — at approximately 6.24% all-in it remains attractive in absolute terms. But the relative case for reaching down the capital structure has weakened somewhat over three weeks, and investors who acted on the earlier observation should recognise that the opportunity has largely been captured.

• One further observation. Credit spreads widened this week while equities rose and the VIX fell. That combination is unusual — credit and equities normally move together in risk terms. When credit widens against a rising equity market, the cause is more often technical than fundamental: new issuance requiring concessions, or spread product cheapening against a sharply repricing rates curve. And that is exactly what happened: credit supply was on the heavy side, which nudged senior spreads wider.

• Nothing in this week’s data suggests any change in the ability of Australian banks or investment grade corporates to service their debts.

Outlook

• The central case. Inflation is proving more persistent than markets assumed six months ago, policy rates stay higher for longer in both Australia and the US, and growth slows gradually without breaking. Australia is the harder case: inflation persistence sits alongside contracting business investment and a softening labour market, which limits the RBA’s room to move in either direction.

• Central banks. The RBA now faces exactly the upside inflation risk its August Statement said would prompt further tightening — a trimmed mean holding at +3.6% YoY against an expected fall, household spending at +7.0% YoY, consumer inflation expectations at 4.9%. Against that: employment down 16K, unemployment at 4.5%, capex down 3.6% and construction down 2.1%. We will not forecast the decision, but the market has moved decisively — BBSW at a one-year high, three-year swap up 12 bps — and anyone positioned for near-term cuts is now positioned against a clear signal. Q2 GDP on 2 September is the next test, with consensus at +0.3% QoQ and annual growth slowing to +1.8% YoY from +2.5% YoY; given the capex and construction figures, we see genuine downside risk. A weak print alongside +3.6% YoY core inflation would sharpen the dilemma considerably.

• The Fed faces sticky core PCE at 3.3% and an upward Q2 revision against internally contradictory survey data — with the two-year Treasury at a one-year high, the market appears to have concluded inflation persistence outweighs the survey weakness.

• Inflation. Risk has shifted upward in both Australia and the US. Australia’s trimmed mean has not fallen in two months and the monthly rate accelerated, with household spending at +7.0% YoY giving firms pricing power; oil retracing 5.4% helps the headline but not the core. US core PCE has held at +3.3% YoY for three months. Europe remains the exception, with expectations converging on target.

• Growth. Deteriorating at the margin, regionally uneven. Australia’s business sector is contracting while its consumer spends strongly — an unusual and probably unsustainable divergence. US hard data points to gradual rather than sharp slowing despite conflicting surveys. China continues to weaken; Europe continues to improve modestly.