Bond Watch: inflation jump is bad news for bonds

UK inflation for the 12 months to the end of July was 3.8%, well ahead of the Bank of England’s 2% target and ahead of expectations from economists.  

For comparison, European Union inflation is just over 2% and inflation in the United States is 2.7%.  

In response, investors priced in fewer interest rate cuts this year, sending bond yields higher.  

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Inflation also eats into the “real” return from bonds, as their payments are fixed (unless you own inflation-linked bonds). 

Long-dated gilts now yield more than at any point since the late 1990s, with the 20-year yielding 5.45% and the 30-year at 5.6%. The 10-year gilt yields 4.75%.  

Marcus Jennings, fixed income strategist at Schroders, said: “With core inflation heading higher, beating market expectations, this brings further into question the Bank of England’s ability to ease interest rates in the near term.” 

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Part of the concern from investors is that the closely watched services inflation measure rose more than 5% year-over-year.  

However, volatile airfares helped drive inflation higher over July, which could reverse in the coming months, according to Jennings.  

In fact, according to the Office for National Statistics (ONS), airfares were up a staggering 30% month-over-month – the highest monthly increase going back to 2001.

Deutsche Bank says that this is good news as most of this will unwind in the next month or so. 

Sanjay Raja, chief UK economist at the German bank, said: “We expect inflation to push a little higher to near 4% year-over-year in September, before slowly grinding its way lower through the course of the year.” 

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Raja now only sees inflation returning sustainably to the 2% target in 2027, with wage disinflation taking time to feed through to price data.  

He concludes: “The Monetary Policy Committee may look for more patience going forward as it grapples with an uncomfortable trade-off: high near-term price momentum versus sluggish labour market data.” 

High and rising inflation, coupled with low economic growth, puts the Bank of England in a tricky situation. On the one hand, it wants to cut interest rates to stimulate the economy, but on the other, lower interest rates risk stoking inflation further.