A significant part of the bull case for buying bonds today is that interest rates are nearing their peak due to softening inflation. This will then allow central banks to pause rate rises and eventually cut interest rates.
Rate cuts would be great news for bonds, as they make existing bonds and their higher yields more attractive, which drives up their price. It’s what makes buying bonds appealing today, on top of the high yields, even though there could still be more interest rate rises in the UK, Europe and the US this year.
But how far off are rate cuts in the UK? Inflation has proven far more sticky than anyone thought, with CPI inflation at 6.8% for the year to July, which was above the 6.7% that economists had forecasted.
The latest inflation reading showed that core inflation, which excludes volatile food and energy prices, was unchanged at 6.9%.
Service prices increased at an annual rate of 7.4%, compared with 7.2% in June, showing that some prices outside of volatile goods, are still rising, which suggests a hard-to-solve inflation problem now that the low-hanging fruit of lower energy costs from a year ago has been harvested.
Hussain Mehdi, macro and investment strategist at HSBC Asset Management, says: “With core inflation remaining stubborn, and following recent upside surprises to GDP and wage growth, there is now a very good chance the Bank of England will implement another 0.25 percentage point rate hike at its upcoming meeting on 21 September.”
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Wage data this week showing that private sector salaries, excluding bonuses, rose by a record 7.8% on an annual basis for the three months to June, also suggests that while headline inflation is falling, it won’t settle near the Bank of England’s 2% target for some time, and a certain amount of inflation could become embedded as salaries and prices chase each other higher.
This latest piece of data caused investors to bet that rates would rise to 6% at the peak, up from their 5.25% today.
The Bank of England’s own forecasts see inflation falling to 5% by the end of this year, as lower energy, and to a lesser degree, food and core goods price inflation, improves the CPI number.
It reckons the 2% target will be reached in spring 2025, before dropping further in the medium term due to a slowing economy.
After announcing another rate hike this month, to 5.25%, the Bank said: “Recent data outturns have been mixed. However, some key indicators, notably wage growth, suggest that some of the risks from more persistent inflationary pressures may have begun to crystallise.”
Where will interest rates fall?
Steven Bell, chief EMEA economist at fund manager Columbia Threadneedle, says that while rates are set to fall in the US this year, where inflation is already at 3%, in the UK cuts will only come in 2024.
Bell says the disappointing UK inflation figures are driven by the lagging impact of higher import costs, which take a full 12 months to work through the supply chain.
The weight of the data therefore suggests that the UK is not out of the woods yet in in its fight against rising prices – so bond prices could have further to fall. So far, the typical gilt fund, including income reinvestment, has dropped 4% in 2023. The average sterling corporate bond fund is flat this year, including income reinvestment.
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Mehdi says: “It’s clear that the extent of UK monetary policy tightening required will be more substantial than in the US and Eurozone. The persistent shortfall in UK labour supply is translating to upward pressure on wages, and thus the need for a ‘higher-for-longer' interest rate scenario. The big question is whether the UK economy can withstand the market’s expectation of a 6%-ish terminal rate and no cuts until later in 2024. This outcome raises recession risks in a housing-dependent economy.”
Nevertheless, Vanguard, the US fund manager, thinks the market’s expectation for interest rates to peak at 6% is excessive.
Shaan Raithatha, senior economist at Vanguard, said: “Real incomes are set to drop sharply and will eventually trigger recession. We now expect the Bank Rate to peak at 5.5-5.75% and for it to stay there until at least mid-2024.”
While he takes a more generous view than the market, he is clear that there is a divergence in the inflation drivers in the UK compared with other countries.
“In our view, one of the reasons behind the divergence is that the UK has suffered from the worst of both worlds in terms of inflation drivers: a US-style labour supply shock and a eurozone-style energy and food price shock.
“Further, UK monetary policy has been less effective and is taking longer to feed through to the economy than in the past. But with 490 basis points of rate hikes already baked in the cake, there is more pain to come, especially for mortgage-holders,” he said.
Is there any positive news?
Bell also adds that there are some positive signs in the fight against inflation. One is that last year’s weakness in the pound has been replaced by strength, meaning a 2% boost to inflation will reverse this year, with another 1% decline set to come through in 2024.
Another positive factor he argues is that the UK economy is actually doing all right, on par with the US, and certainly better than Europe, despite all the negativity in the news headlines.
“While there is much focus on the current pain in the housing and mortgage markets, we think that mortgage costs have likely peaked and that, while house prices will decline by around 10% from their peak, the worse is passed, leaving prices still above pre-Covid levels,” he said.
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So, what does all this gloom mean for investors? Interest rates higher for longer points to bad news for the economy, and therefore company profits. It’s also not good news for bond prices, but with yields rising still, investors can get a good return while they wait for inflation to convincingly fall.
Current gilt yields are over 5% for bonds maturing in one and two years, while five and 10-year bonds pay 4.6%. Rising yields on longer-dated gilts are a sign that investors think interest rates will be higher for longer, meaning investors are getting a better nominal return on their money.
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