UBS: Market Overpricing Fed Rate Hike in October; Core PCE Revision Weakens Case for Consecutive Hikes

The sharp rise in U.S. Treasury yields has triggered market turbulence, but UBS believes current market pricing for the Federal Reserve's tightening path is overly aggressive. The firm argues that actual policy tightening may fall short of expectations, and the overall investment outlook remains constructive.

Yield Spike and Market Reaction

The 10-year U.S. Treasury yield surged nearly 15 basis points in a single day, breaking above 5.1%—a level not seen since 2007. The S&P 500 fell 0.8%. The move was driven by a combination of rising oil prices, strong economic data, and weak Treasury auction results. As a result, the implied probability of an October rate hike in federal funds futures jumped to 70%, up sharply from below 50% just a week earlier.

UBS: Tightening Expectations May Be Overstated

According to a report from UBS Chief Investment Officer Mark Haefele and his team, the actual degree of Fed tightening is likely to be lower than what current market pricing suggests. UBS's base case scenario calls for one more rate hike in December, followed by rates held steady. The firm also expects the core PCE inflation measure to be revised downward by 0.2 percentage points this month through the Bureau of Economic Analysis's annual revision. Combined with favorable base effects in the first half of next year, the foundation for consecutive aggressive rate hikes is weakening.

PCE Revision as a Key Variable

UBS notes that while recent Fed officials' rhetoric has leaned hawkish, market pricing for the tightening path has exceeded what fundamentals can support. The report points out that the median interest rate forecast from Fed policymakers implies rates remaining unchanged throughout 2027. A downward revision to core PCE inflation would further compress the scope for consecutive rate increases.

Specifically, the upcoming annual revision by the Bureau of Economic Analysis is expected to lower core PCE inflation by 0.2 percentage points. This adjustment could ease market concerns about persistent inflation. Meanwhile, favorable base effects in the first half of next year are expected to support a steady disinflation trend over the next six months. Taken together, these factors significantly reduce the need for a prolonged series of rate hikes by the Fed.

Strong PMI Data Supports Corporate Earnings

The economic data that triggered the recent yield surge also carries positive implications, according to UBS. The S&P Global U.S. Composite PMI flash reading rose to 58.4 in September, marking the fourth consecutive month of accelerating expansion and the strongest private sector activity since July 2021. This confirms the view that the U.S. economy continues to operate robustly.

UBS believes that resilient economic activity provides a favorable environment for corporate revenue and profit growth. Combined with additional momentum from ongoing AI investment, the firm expects S&P 500 earnings to grow 25% this year and 14% in 2027. On a global scale, the MSCI World Index is forecast to see earnings growth of 26% this year and 14% next year. This improving earnings cycle should support global equity markets over the next 6 to 12 months.

Rising Yields Create Structural Opportunities in Fixed Income

UBS acknowledges that concerns over debt levels are one factor behind the recent rise in bond yields. However, high debt levels do not automatically translate into poor investment returns; the impact depends on how individual governments manage their debt.

Against this backdrop, UBS maintains an "attractive" rating on fixed income assets, noting that higher initial yields provide a solid income base for portfolios. For yield-focused investors, short-duration bonds can effectively reduce interest rate risk. At the same time, UBS sees tactical opportunities in medium- to long-duration high-quality bonds and investment-grade corporate credit from issuers with strong ratings, advising investors to position at current yield levels.

France-Germany Spread Widens, Eurozone Assets Show Divergence

In European markets, the spread between French and German 10-year government bond yields widened by 6 basis points on Wednesday to 110 basis points—the highest level since July 2012, when then-ECB President Mario Draghi pledged to do "whatever it takes" to defend the euro. The French 10-year yield rose 15 basis points to 4.66%, significantly outpacing the move in German Bunds.

UBS attributes the widening spread primarily to market concerns over France's fiscal situation and next year's presidential election, rather than a simple spillover from the global bond selloff. France's fiscal deficit exceeds 5% of GDP, and the financing costs for its €2.7 trillion in government debt have risen sharply, potentially leading to further credit rating downgrades. French bond yields are now even higher than those of BBB-rated Italian bonds, suggesting the market has positioned French debt as a rate-sensitive, high-beta asset. Nevertheless, UBS does not see an imminent severe fiscal crisis and maintains a positive view on eurozone equities, arguing that improving economic activity and earnings growth can offset valuation pressure from moderately rising yields.

Gold Under Short-Term Pressure, but Medium- to Long-Term Value Remains

Gold has come under pressure, falling below $4,300 per ounce to trade around $4,280, with a cumulative decline of more than 8% over the past month. Hawkish Fed rate hike expectations and a strong U.S. dollar pose near-term headwinds.

UBS acknowledges that gold's short-term volatility may increase further amid rate hike expectations and a "higher for longer" interest rate outlook. However, the firm remains constructive over a 12-month horizon. Continued central bank gold purchases, reserve diversification needs, high government debt levels, and geopolitical uncertainty all provide medium- to long-term support for gold. UBS views a pullback toward $4,000 per ounce as an opportunity for investors to increase positions and forecasts gold prices rising to around $5,400 per ounce by September 2027.

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