Interactive Investor

Benstead on Bonds: interest rate outlook, and why stocks have rallied too much

17th August 2022 08:55

by Sam Benstead from interactive investor

Share on

Sam Benstead’s first monthly column on the bond market and its insights for DIY investors delves into inflation, interest rates, and a worrying ‘decoupling’ between stocks and bonds.

Sam Benstead 600

Welcome to the first Benstead on Bonds column, a monthly analysis on the bond market where I will focus on the lessons everyday investors can take from what the City’s most sophisticated investors are up to.

Bond investors are considered the “smart money”, hypersensitive to shifts in the macroeconomic environment and laser-focused on getting their money back, rather than finding the next super-star stock.

This means bond markets contain brilliant clues about what will happen to inflation, interest rates, economic growth – and the stock market – while also offering savvy investors income streams and the chance to make money on their capital as well.

So, what’s the most important thing DIY investors need to know about what’s happening in bond markets right now? Without doubt, it’s that bond investors expect interest rates to fall next year, even as inflation continues to roar near double digits in the US and Britain.

This has huge implications for personal finances, such as fixing mortgages or locking in savings rates, as well as what the stock market will do.

Why is this? It’s because investors and economists expect inflation to fall next year, which will ease pressure on central banks, leading to them cutting rates next year to stimulate flagging economies.

This is more likely in the US than the UK, as inflation across the pond has already begun to slow, while inflation is expected to peak this winter at home due to higher fuel costs.

Inflation is measured year-over-year, so as we begin to “lap” high prices, then annual comparisons begin to look more favourable as supply constraints caused by the pandemic are no longer factored in, such as in semiconductors or used cars.

The expectation that inflation will fall is also due to fears about economic growth, which is reflected in a lower oil price. Oil has fallen around 30% from its peak, with a barrel of Brent now costing $94 compared with $130. One year ago, a barrel cost about $70.

Ariel Bezalel, head of fixed income strategy at Jupiter Asset Management, thinks that by the autumn the US Federal Reserve will pause its rate rises and then start cutting rates next summer.

Bezalel told me: “I'll be surprised if we do get as high as 3.5% interest rates in America, and I think the cuts are going to be somewhat more aggressive as the inflation picture turns around pretty dramatically, pretty swiftly."

Morningstar, the financial data firm, expects the US central bank to ease monetary policy in 2023 as inflation falls back to the central bank's 2% target and the need to shore up economic growth becomes paramount. It forecasts a peak of 3% rates at the start of 2023, before dropping to 1.5% by 2024. Interest rates in the US are 2.25% to 2.5%.

In the UK, the Bank of England said inflation would begin to fall next year, as it was unlikely that prices of energy and imported goods would continue to rise as rapidly as they have done recently.

It added that the production difficulties businesses are facing will ease and less demand for goods and services in the UK should also push down prices. It has a 2% target for inflation and expects to hit that again in two years’ time.

Another clue about rates can also be found in the short-term interest rates of US and UK government bonds. The two-year US Treasury bond yields 3.2%, and the two-year UK gilt yields 2%, compared with a Bank rate of 1.75%.

These yields are an indication of what investors think rates will be over the short term. If they thought that rates would rise significantly higher, then they would demand a higher return on their cash.

So, what should investors take from this unexpectedly rosy outlook from the bond market? The first is that peak inflation and peak interest rates are not far off. If inflation falls next year, along with rates, then we will feel better off, so long as a recession has not led to job losses.

Falling inflation and rates is also great for stocks, which benefit when the bonds yields fall as stocks – particularly those that promise profits way out in the future – become relatively more attractive.

Look to US shares for the biggest bounce-back if markets see rate falls happening sooner than expected: the S&P 500 index of its biggest firms has recovered 17% from its low point in mid-June. It needs to rise only another 11% to be back at all-time highs again.

However, the stock market may have got ahead of itself. A chart that caught my eye this week came from Alfonso Peccatiello, a former fund manager and now financial commentator.

Peccatiello charted the real (inflation-adjusted) US 10-year Treasury yield against the S&P 500 index, showing that since the start of August, stocks have rallied strongly but bonds have fallen (sending yields higher).

The stock market is celebrating while bond investors are waiting to see better economic data when it comes to inflation falling. Stocks and bonds have moved in tandem for much of the year, so this decoupling suggests that the road higher for stocks may not be a smooth one.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

Get more news and expert articles direct to your inbox