Bond Watch: inflation jump sparks gilt sell-off

Gilt yields rose (and prices fell) this week due to an higher-than-unexpected jump in inflation.

The Office for National Statistics (ONS) calculated that the Consumer Price Index (CPI) rose 3.5% in the year to April, ahead of 3.3% expected by economists. The March CPI inflation figure was 2.6%.

The Bank of England expects inflation to peak at 3.7% this summer.

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The rise in prices was down to higher energy costs and water bills, as well as higher airfares. Service inflation also rose to 5.4%, ahead of a 4.8% expected rise.

The inflation print likely means that the Bank of England will be more hesitant to cut interest rates this year. Fewer rate cuts is bad news for gilt prices, and has caused the rise in yields.

Markets are now pricing just one more interest rate cut this year, which would mean interest rates hitting 4%.

10-year gilts now yield 4.7%, whereas those maturing in less than four years pay about 4% if held to maturity. The longer the maturity of the gilt, the higher the yield, with 30-year gilts currently yielding 5.5%.

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Adding to the woes for gilts this week were comments from Bank of England chief economist Huw Pill. He said that the pace of interest rate cuts was “too rapid”, which led investors to dial back expectations for interest rates cuts this year.

Sanjay Raja, chief UK economist at Deutsche Bank, said that forecasts for the April data “clearly underplayed” the effects of the later-than-usual Easter alongside tax changes in the transport basket.

However, looking ahead he’s more optimistic, saying that rates will continue to fall this year.

Raja said: “Big picture, this is not the end of a quarterly cutting cycle – not yet at least. While the bar may be higher for an August rate cut than previously thought, it’s likely that the majority of the Monetary Policy Committee will look past this if inflation expectations start to recede as we expect them to ahead of the August decision, the labour market continues to loosen as we expect, and pay settlements continue to come in lower.”

Nevertheless, he argues that a June interest rate cut is now off the table, while an August cut still seems likely.

US Treasury downgrade – does it matter?

Adding to the woes of bond markets this week was credit rating agency Moody’s downgrade of US government debt one notch to Aa1 from AAA. This takes it off the highest rating due to concerns around growing government debt and rising interest costs.

There was also a weak auction for 20-year US government bonds this week, sending yields above 5%, as investors continued to shun US debt.

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George Saravelos, global head of FX research at Deutsche Bank, said that the market has reacted very negatively to a poor US Treasury auction.

He noted that the most troubling part of the market reaction was that the dollar was weakening at the same time.

“To us, this is a clear signal of a foreign buyers’ strike on US assets and the associated US fiscal risks we have been warning [about] for some time. At the core of the problem is that foreign investors are simply no longer willing to finance US twin deficits at current level of prices.”

Bond markets, like equity markets, can move in tandem around the world, so rising US yields can also lead to rising UK government bond yields. This causes gilt prices to drop, but leads to higher yields for new investors.