Interactive Investor

Bond Watch: inflation falls but investors aren’t impressed

16th September 2022 09:09

by Sam Benstead from interactive investor

Share on

Sam Benstead runs through the most important news stories of the week for bond investors.

Bonds screen 600

Welcome to interactive investor’s weekly ‘Bond Watch’ series, covering the latest market and economic news – as well as analysis – that is relevant to bond investors.

Our goal is to make the notoriously complicated world of bond investing simpler, by analysing the week’s most important news and distilling it into a short, useful and accessible article for DIY investors.

Here’s what you need to know this week.

A big, bad week for inflation

On the surface, inflation data for August in the United States and Britain released this week was good. In the US, the annual inflation rate fell from 8.5% in the 12 months to July, to 8.3% in the 12 months to August. That marks two straight months of falling prices. In Britain, inflation fell from 10.1% to 9.9%.

But what matters in investment is expectation versus reality. If inflation falls and it was forecast to rise, then this is great news for stocks and bonds. On the other hand, if inflation falls just a bit but it was expected to fall a lot, then that’s bad news.

In the US, investors thought inflation would come in at 8.1%, so the numbers were worse than expected. But the underlying inflation data painted an even worse picture. Core inflation, which strips out volatile items such as energy and food prices, actually rose to 6.3% year over year. This was more than the 5.9% July reading.

This suggests that inflation is becoming more embedded, and not just a consequence of higher commodity prices. In response, the S&P 500 index of America’s largest shares plummeted 4%, and the US 10-year Treasury bond yield rose 2%, to 3.4%.

Yields move inversely to prices. Bond prices fall when investors expect interest rate rise, and tend to fall when they forecast interest rate cuts.

In the UK, while inflation came in slightly lower than expected, and the government’s emergency fiscal package to bail out households facing steep energy bills this winter was announced, the outlook for prices is still scary. Inflation only fell because of a drop in petrol prices, and UK inflation remains the highest of any G7 nation.

Food inflation rose to 13.1% in the 12 months to August, up from 12.7% in July. The current rate is the highest since August 2008, according to the Office for National Statistics. The 10-Year UK Gilt now yields 3.15%, up from around 3% before the inflation number this week.

More pain to come for bonds

Jim Reid, head of global fundamental strategy at Deutsche Bank, found in a survey of 400 professional investors that the majority are still bearish on bonds and inflation.

His research showed that 73% of investors think that that US 10-Year Treasury will hit a 5% yield before it hits 1%, meaning that bond prices are more likely to fall substantially than rise. This is up from 60% of investors who believed it in April this year.

However, the bank, which is one of the City’s most pessimistic about inflation and economic growth, has now revised down its forecasts for UK inflation in light of Liz Truss’s support package for energy bills.

Reid said: “Beyond September, we have taken down our inflation projections a little bit. With the energy price guarantee in place, we now see the peak in CPI at just over 10.5% year over year, when it was previously forecast to be 14%.”

It now expects an average inflation rate or 7% in the UK in 2023.  

It’s not all doom and gloom

On the other hand, some fund groups see the bond sell-off and the general pessimism among investors as a sign that things could be about to get better for bonds.

Citywire, the financial publisher, reports that French group Amundi believes “bonds are back”, with its chief investment officer Vincent Mortier saying that the selloff meant possible capital returns and income were now attractive from a risk-reward perspective.

He said: “The returns and risk premium between stocks and bonds in the last month has been rebalanced to bonds overall.”

Mortier highlighted the defensive qualities of US government bonds in periods of macroeconomic and geopolitical market shocks, saying that a buy-and-hold approach in investments with a maturity of between four and five years is currently “very attractive”, Citywire reported.

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