The government reported that, in August, the CPI was up 3.4% from a year earlier, which was the same level as July. The annual rate of inflation has exceeded 3.3% every month since the Middle East conflict began—a level not exceeded since April 2024. In addition, the government reported that the CPI was up 0.3% from July to August—the highest since April.
Energy played a big role in this: Energy prices were up 16.3% in August versus a year earlier, and up by 2.1% from the previous month. Gasoline prices were up 27.4% from a year earlier and up 3.9% from the previous month. Finally, the price of fuel oil (used to heat buildings) was up 52% from a year earlier and up 10.1% from the previous month. Plus, the average retail price of diesel hit a record high on the day of writing. All of this reflects the sharp rise in the price of crude oil and the continuing global shortage of refinery capacity.
When volatile food and energy prices are excluded, core prices were up 2.4% from a year earlier—down from 2.5% in July and the lowest since March 2021. Core prices were up 0.3% from the previous month—the highest since April. Although annual core inflation has decelerated, the month-to-month increase could indicate potential acceleration. It will depend on what happens with overall inflation and the degree to which energy-price inflation spills over into non-energy goods and services. And this is happening to some extent: For example, airlines fares (which are influenced by the cost of jet fuel) are up 23.4% from a year earlier.
The news on inflation, combined with last week’s relatively strong jobs report as well as news about events in the Middle East, appears to have reinforced investor concerns that there is higher inflation to come. That, in turn, coincided with a further rise in the yield on the US Treasury’s 10-year bond. At the time of writing, it hit 4.96%—the highest in three years. Moreover, investor expectations about Fed policy shifted accordingly. The futures market’s implied probability that the Fed will hike the benchmark interest rate when it meets next week increased from 72.4% yesterday to 86.5% today. Plus, the implied probability of at least one rate hike before the end of the year increased from 94.4% yesterday to 97.5% today.
These numbers have led market participants to question how the Fed could possibly not raise the benchmark interest rate next week. After all, if it doesn’t, markets will likely react negatively, expecting even higher inflation. Yet, there is now plenty of market commentary about whether Fed Chair Warsh will be willing to raise rates. If Warsh votes not to raise rates, the committee might defy him; but this has rarely happened before. Such a move could be viewed as reducing his authority at the Federal Reserve. If he votes to raise rates, he will possibly face criticism from the administration, as well, which favors a cut in the benchmark interest rate. Either way, next week may prove to be a difficult time for him.
Many analysts view the Houthi action against Saudi Arabia as a proxy war between Iran and the Saudis—one in which Saudi Arabia’s oil infrastructure is highly vulnerable. One result of the attacks, which included action against Saudi oil-production facilities, is that Saudi crude-oil production has fallen to its lowest level this year. That, in turn, is one of the reasons why the price of Brent crude hit US$107 per barrel late last week—the highest since May and up by more than US$20 per barrel since late August.
The yield on the US Treasury’s 10-year bond hit 4.96% last week—the highest in three years. This was part of a global trend. In the United Kingdom, the yield on the 10-year bond hit 5.38%—the highest since 2007. And, in Germany, the 10-year bond yield hit 3.5%—the highest since 2011 and up 65 basis points since July.
The sharp rise in global bond yields, which has taken place steadily over the last two months, is now the prime focus of financial market observers. That is because it has a significant impact on credit-market activity and on the fiscal stance of major governments. A vigorous debate is underway about the primary causes of the rise. Among the possible causes are elevated inflation expectations, expectations of monetary policy tightening, increased bond sales by tech companies, and growing anxiety about the unsustainable fiscal stances of major governments.
Meanwhile, the rise in bond yields has affected the prices of other assets. In the United States, the interest rate on a 30-year fixed-rate mortgage passed 7% last week, which could potentially have a further negative impact on housing-market activity. Indeed, US sales of existing homes have fallen in each of the last three months. Other borrowing costs are rising commensurately, raising concerns about the cost of credit for businesses, especially tech companies that have issued a lot of debt.
The rise in bond yields is related to concerns about inflation, stemming from the rise in oil prices. However, it is not only oil prices that have risen. The commodity price index, published by the Commodity Research Bureau, is now up 40% since February. This reflects the rise in oil and gas prices as well as prices of other important commodities.
In addition, it might also reflect the downward pressure on the value of the US dollar. The rise in commodity prices has shown up in significantly higher prices for diesel and jet fuel as well as the cost of semiconductors and other important components. Overall, this could contribute to inflationary pressures and a potential reduction in the purchasing power of both consumers and businesses.
In the past six months, the physical shortage of crude oil was partly offset by the release of crude reserves by major countries, especially China. However, it is reported that investors are beginning to worry that those reserves will soon be depleted, in which case, the shortage could only be resolved by a sharp increase in price that would suppress demand and reduce it to the level of supply. If that happens, global inflation could accelerate further, likely leading to tighter monetary policy around the world.
Meanwhile, the US Treasury continues to purchase long-dated bonds in the hope that this will suppress bond yields. US Treasury Secretary Bessent said that current yields do not reflect market fundamentals. Thus, the goal is to convince investors that the market is not on “a one-way trip.” That is, he sees the market as being driven by fear rather than fundamentals and is trying to shift the focus. However, the upward movement of bond yields recently, both in the United States and elsewhere, likely reflects investor concerns that inflation risk is rising and, consequently, the risk of tighter monetary policy is rising. As such, bond yields appear to respond to what is happening in the larger economy.
Also, it is worth noting that, although the yield on the US 10-year bond is approaching 5%, this is a level that was considered normal not long ago. After all, just prior to the start of the global financial crisis in 2008, the yield was about 5%. Moreover, for all of the time from the late 1960s until 2000, the yield was above 5%, sometimes much higher. It was only in the period between the global financial crisis and the pandemic that the yield was consistently much lower. Thus, some analysts have suggested that we are returning to normalcy and that there is no need for panic. This would be especially true if the massive investment in artificial intelligence boosts the average growth rate of the economy.
Finally, the events in the Middle East have contributed to a significant shortage of liquified natural gas (LNG), with considerable impact observed in Europe. The last time there was a major LNG shortage (in the early days of the Russia-Ukraine war), European governments took steps to stockpile gas for the cold winter months.
This time is different, however. The amount of gas in storage in Europe is now at the lowest level in 15 years. Gas tanks are now about 67% full—down 13 percentage points from a year ago. Why? It is reported that European buyers expected that the Strait of Hormuz would be opened by now. But it remains closed and gas is not flowing.
On the other hand, European officials say that Europe has been successful in diversifying sources of gas, and diversifying energy production away from gas. If so, lower inventories may not necessarily be a problem.
As it is, China continues to have excess capacity, and some other countries have accused China of subsidizing exports and selling them at prices below cost. Indeed, many Chinese industrial companies are not profitable. There is growing backlash in many countries against China’s aggressive exporting, especially in Europe, where the automotive industry now faces increasing competitive pressure.
Meanwhile, in Europe and North America, there is concern about the dominant position that China maintains in several key inputs for manufacturers of automobiles and high-tech equipment. This has given China leverage in negotiations with the United States when it comes to trade restrictions. Indeed, late last year, some automotive factories in North America had to temporarily shut down because China withheld exports of semiconductors made by Nexperia, which are used in airbags and braking systems.
China only relented after the United States agreed to postpone the implementation of a new export-control regime. China now accounts for 30% of global industrial output—a number that is expected to rise in the coming years.
The counterpart to China’s trade surplus is a massive outflow of capital, reflecting China’s excess savings relative to investment. It also reflects suppressed domestic demand, a fact that China’s government acknowledges but has so far failed to adequately address through restructuring or stimulus. Thus, China continues to rely on exports for economic growth rather than domestic consumption.
The outflow of capital is the counterpart to the rest of the world’s trade deficit. China is investing massively in multiple countries, including advanced economies in Europe and Asia as well as emerging economies around the world. The risk is that, if China’s export boom ends and the surplus diminishes, the flow of capital from China to emerging countries could slow significantly.
Plus, China’s input and commodity imports from emerging countries could weaken as well. Thus, although it would be in the interest of China and the rest of the world to unwind the large surplus, the process of doing so could be hugely disruptive to the global economy.
Interestingly, until about a decade ago, much of China’s surplus was invested in US Treasury securities. However, starting in about 2015, China reduced its exposure to US bonds. Other countries followed suit. The result is that the share of US Treasury securities held by foreign governments fell from about 35% in 2015 to about 12% today. This means that, for the United States to continue running large budget deficits, it must find buyers for its bonds in the private sector.
In any event, let’s look at the latest numbers: In August, Chinese exports (denominated in US dollars) were up 25% from a year earlier—the third consecutive month in which exports grew by more than 24%. Products that support the buildout of AI accounted for half of the growth in exports. Specifically, exports of integrated circuits were up almost 130% from a year earlier. Exports of high-technology equipment were up 57% from a year earlier. On the other hand, vehicle exports were down. Thus, China’s export performance appears to be increasingly linked to the surge in AI investment.
In fact, the pattern of China’s export growth by country may also reflect the influence of AI-related investment. Consider the United States: When it first introduced high tariffs last year, Chinese exports to the United States fell sharply for many months. That is no longer the case. In August, Chinese exports to the United States were up 34.4% from a year earlier. Notably, exports to the European Union were up only 6.6%—the slowest rate in 10 months. This is not surprising given that Europe is not as big a participant in AI supply chains as the United States. Meanwhile, Chinese exports were up 30.2% to Southeast Asia and up more than 40% to both South Korea and Taiwan.
China’s imports grew 28.2% in August versus a year earlier. This was roughly in line with the pace of import growth over the last five months. The strength of imports was also strongly related to the buildout of AI. For example, imports were up 108.1% from South Korea, up 41.5% from Taiwan, up 20% from Japan, and up 35% from Southeast Asia. In addition, imports were up 17.8% from the United States but up only 0.7% from the European Union. The remarkable growth of imports from South Korea likely reflect that country’s strong position as an exporter of AI-related chips.
Prior to this, the yield had not been higher since 2023. Meanwhile, the yield on the 30-year bond hit the highest level since 2007. To date, the US Treasury’s effort to influence long-term yields through market intervention has not had a sustained impact, which suggests that intervention without changes in market fundamentals may sometimes have unintended market reactions.
It might convince some traders that things are worse than expected. The latest incident in the Strait of Hormuz appears to have reinforced concerns that the crisis could persist, potentially leading to higher inflation. Futures markets now show an implied 68% probability that the Fed will raise the benchmark interest rate in September.
In the United Kingdom, the yield on the 10-year gilt hit 5.2%—the highest since June 2008—likely reflecting a view that inflation will accelerate. Moreover, futures markets are now pricing in a 70% probability that the Bank of England will hike the benchmark interest rate in November. With memories of the tenure of Liz Truss hanging over new Prime Minister Andy Burnham, the Chancellor of the Exchequer John Healey will present a budget in October. The new government must navigate a difficult path, attempting to appease bond investors while pleasing voters with favored spending programs.
If bond investors interpret the budget as not addressing fiscal issues, bond yields could rise sharply. The government cannot afford such an outcome, given Britain’s borrowing costs already exceed those of the United States, Germany, and France.
Meanwhile, in Germany, the yield on the 10-year bond hit 3.36%—the highest since April 2011. The yield in France hit the highest since 2008, and yields in Italy and Spain hit their highest levels in three years. Investors generally expect the European Central Bank to raise its benchmark rate in September. Futures markets now show an 80% probability of another rate hike in December.
In Japan, the yield on the10-year government bond briefly surpassed 3% for the first time in three decades. While the latest surge may partially reflect the potential inflationary impact of events in the Middle East, traders are also focused on Japanese fiscal policy as well as interest differentials with the United States. Yields also increased in other East Asian countries.
All of this raises an important question: Are higher yields a bad thing? And, as in many other aspects of life, the answer is: It depends.
Bond yields generally move to bring supply and demand for loanable funds into balance. If demand for funding rises in relation to supply, yields will often tend to rise, and vice versa. If the performance of an economy improves, leading to greater profitable investment opportunities, the equilibrium yield could rise, which would not necessarily be a bad thing. If, however, demand for funds rises relative to supply because of a lack of fiscal probity, yields may rise, potentially stifling private sector credit activity. Or, if expectations of inflation rise and investors require protection from the risk of inflation, yields may also rise and that won’t be a good thing.
Consider the period between the global financial crisis (2008 to 2010) and the COVID-19 pandemic (2020 to 2021): This period was characterized by historically low inflation and historically low bond yields. Some economists suggested that, in part, the low yields reflected an excess supply of savings in the world relative to investment opportunities. It might have been related to weakness in aggregate demand in the global economy.
Now, fast forward to the current situation: We have higher expectations of inflation, which may partly explain the rise in yields. And we have historically large budget deficits in several major countries, which may also explain such high bond yields. But we also have a new, revolutionary technology that has led to massive growth in investment. It has led to expectations of strong productivity growth and potentially faster economic growth. These, too, might partly explain the rise in bond yields. In that sense, higher bond yields could be seen as reflecting a better economic picture.
Indeed, yields that are too low can lead to poor capital allocation. If yields are closer to zero, there is effectively no opportunity cost associated with making bad investments. A high yield can have a disciplining effect on capital markets, likely directing capital toward the most potentially profitable use cases.
Consider the case of Japan which, until recently, had yields near or below zero. It also had a prolonged period of suboptimal growth. Yet now, the yield on the government’s 10-year bond is around 3%—the highest since the mid-1990s. Some analysts suggest that this is a sign of economic health, and could mean that the country has many favorable investment opportunities, and that Japan could soon return to a sustained higher rate of growth.
On the other hand, Japan faces higher-than-desired inflation. In addition, it faces a potentially disruptive level of government debt. These factors partly explain higher yields. And Japanese yields have suddenly risen sharply, which was probably not just due to a sudden improvement in economic prospects. As such, it remains unclear whether Japan’s economy is capable of supporting the 3% yield. In any event, at the very least, the high yields will likely mean that capital will only flow to the best opportunities.
One factor that has lately contributed to higher yields is the rise in energy prices. Last week, the price of Brent crude went as high as US$97 per barrel before somewhat retreating. Just a week earlier, the price was under US$88 per barrel. The sharp rise appears to be related in part to the conflict between Iran and the United States. During the week, there has been a return to hostilities between the two countries. Moreover, there does not appear to be any movement toward a resolution, either. If higher prices are sustained, they could add to inflationary pressures around the world.
Meanwhile, the price of European natural gas has increased sharply—hitting the highest level since early 2023. In just the past month, the price has risen roughly 40%. About 20% of globally traded liquified natural gas travels through the Strait of Hormuz, mostly coming from Qatar, and much of it goes to Europe. This route has been disrupted. Plus, the winter season is approaching while European gas reserves are at a level below normal. The latest inflation data from the European Union showed acceleration, thereby boosting the likelihood of further tightening of monetary policy by the central bank.
Finally, as mentioned above, US yields temporarily fell last week after Federal Reserve Governor Christopher Waller spoke about the future trajectory of monetary policy. Specifically, Waller said that he “would be inclined to support holding the target for the federal funds rate at its current setting.” He said that his decision at the upcoming meeting this month will be determined by data. Specifically, he said that “if there is continued progress toward our 2% goal, then I am willing to support holding the policy rate at its current level. But if inflation comes in hot, I would consider a rate hike.” Following Waller’s comments, the future market’s implied probability of a rate hike this month dropped from 63.2% to 50.3%.
The comments from Waller, which follow comments by New York Federal Reserve Bank President John Williams suggesting that inflation is being tamed, led not only to a drop in US bond yields but also a decline in the value of the US dollar.
The global selloff of government bonds appears to reflect multiple risks in the global financial system. These include expectations of higher inflation, expectations of tighter monetary policy, concern about fiscal policy in multiple countries, and concern about the massive issuance of bonds by tech companies.
Yet, equity investors appear to be largely focused on artificial intelligence than on those risks. The performance of equity prices likely reflects the view that, despite short-term headwinds and risks, massive investment in AI could generate sizable positive returns in the near future.
Moreover, the probability of two rate hikes this year is now 44.1% while that of no rate hikes this year is only 14.3%. Thus, investors appear to see a significant likelihood of monetary policy tightening this year. Meanwhile, the yield on the Treasury’s 10-year bond increased modestly today on the employment news. In addition, the US dollar rose in value. Let’s look at the details:
The US government releases a monthly report on the jobs market that includes the results of two surveys—a survey of establishments and a survey of households. The establishment survey found that, in August, 162,000 new jobs were created. This was the highest number of jobs created since March, and was a much bigger number than many analysts expected. Moreover, throughout 2026, job growth has been relatively healthy after being relatively feeble in 2025.
As noted, investors greeted the news as evidence of economic strength and potentially higher inflation. President Trump, however, called for lower interest rates, saying that strong employment growth means that the United States is a good credit risk. He has repeatedly called for lower interest rates and, as of the time of writing, once again called on the Fed and its new chair to cut rates. Thus, if the Fed chooses to raise the benchmark rate this month, the new chair could face criticism from the administration.
In any event, the strong job growth was concentrated in just three categories: Employment was up by 28,400 in healthcare and social assistance, up 67,800 in accommodation and food service, and up 50,000 in local government (mostly in education). Combined, these three categories accounted for 90% of US job growth.
Meanwhile, there was moderate job growth in construction and manufacturing, feeble job growth in retail trade, transportation, and professional and business services, and a decline in employment in financial services as well as information. The last category includes computing, data processing, web hosting, and related services. Thus, the tech industry, which is a major source of economic growth, was not a significant contributor to job growth in this report.
Also, the establishment survey provides data on average hourly earnings of all private sector workers, and found that, in August, average hourly earnings were up 3.1% from a year earlier—the slowest growth since May 2021. We know that, in July, the consumer price index was up 3.4% from a year earlier, which suggests that wages are not keeping pace with inflation and potentially weighing on real or inflation-adjusted purchasing power.
Despite this, spending adjusted for inflation continues to rise as households dip into their savings. Yet, with the saving rate being historically low, it is unlikely that it will go much lower. That, in turn, could imply that real spending growth may decelerate or stop in the coming months.
Meanwhile, the separate survey of households found that, in August, the labor force grew much faster than the working age population, leading to a sharp rise in the participation rate. In addition, employment (including self-employment) grew rapidly. The result was that the unemployment rate held steady at 4.1%, implying that the economy is operating at full employment.
Beth Hammack, president of the Federal Reserve Bank of Cleveland, reacted to the latest jobs report saying that, “inflation is still above 3%. The labor market is stable and near my estimate of maximum employment. Both the hard data and the anecdotes are telling me the same thing: Policy is not restrictive. Inflation is too high. And the longer it stays above our objective, the harder it will be to bring it back down.”
Also, recall that, in his speech at Jackson Hole last week, Fed Chair Warsh spoke about the strength of the US job market and also noted that inflation remains too high. Thus, an imminent tightening of monetary policy seems like the logical next step.
It has been estimated that, as of late July and August 2026, global exports of refined products were down 25% from a year earlier. In addition, it has also been estimated that 75% of that decline was attributable to either the Middle East or Russia. In the Middle East, some refining capacity was destroyed by Iran during the military conflict. Plus, refined products are unable to pass through the Strait of Hormuz. In addition, some Russian refining capacity has been destroyed or damaged by Ukrainian drones. As a result, Russian refinery output is now at the lowest level in two years. Indeed, Russia has shifted to importing refined goods.
Another factor was a temporary Chinese ban on exports of refined products. This was undertaken to stabilize domestic supplies of refined products. Although the ban has been lifted, its lagged effects remain.
The impact of the refining shortage is significant: For example, the price of jet fuel is up roughly 74% from a year ago, while the price of crude oil is up a more modest 30%. Plus, there are reports of shortages of refined products used in the manufacturing industry, including naphtha which is used to make plastics, paints, and other important inputs.
Finally, the shortage of refining capacity will likely continue to contribute to inflation and to a loss of household purchasing power in multiple countries. It is an example of how the world’s two major conflicts (in the Middle East and between Ukraine and Russia) are disrupting the global economy.