Bond Watch: ‘stagflation spectre’ haunts gilts

Normally, when the economy weakens, central banks step in, cutting interest rates to boost growth.

The UK’s gross domestic product has now fallen in real terms for two consecutive months – a 0.1% contraction in May followed by a 0.3% contraction in April.

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The unemployment rate has also risen, up 0.2 percentage points from March to May this year to 4.7%.

This economic weakening must have the Bank of England itching to cut rates, which would be good news for bonds, but one factor is holding them back: inflation.

The CPI inflation figure for the year to June came in at 3.6%, ahead of expectations. Core CPI (which excludes volatile items such as food and energy) was 3.7%, while services inflation was 4.7%.

Transport and travel services, hotel prices and motor insurance were all surprisingly high.

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Sanjay Raja, chief UK economist at Deutsche Bank, says that the June inflation figures were ahead of Bank of England forecasts.

“Headline CPI, core CPI, and services CPI all picked up above the Bank of England staff projections. As of the June report, headline CPI sits 23 basis points above the Bank’s forecasts, core CPI sits 7 basis points above the Bank’s forecasts and services CPI sits 16 basis points above the Bank’s forecasts,” he noted.

Rising inflation and a weakening or contracting economy could lead to “stagflation”, which would be a poor backdrop for gilt and bond prices as investors would demand a higher premium (yield) to lend their money to companies and governments.

Neil Birrell, chief investment officer at Premier Miton Investors, said: “The UK employment data was worse than anticipated and average earnings were also higher than expected.

“Given the lack of economic growth, and this coming hard on the heels of worrying inflation data, it must raise the spectre of stagflation in the UK again. The Bank of England are between a rock and hard place ahead of their decision on rates coming up in August.”

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However, Deutsche Bank still thinks that interest rates will be cut in August, to 4%.

“We continue to think that the hump in inflation will be temporary. Indeed, the labour market outlook paints a more disinflationary picture in the medium term. We continue to think an August rate cut looks likely given the weakness in Q2-25 GDP, weakness in labour market indicators and lags in monetary policy transmission. But how far and fast the Monetary Policy Committee go from there will very much rest on the direction of the labour market,” Raja said.

Despite some optimism from Deutsche Bank, investors voted with their feet this week, selling gilts to send yields higher.

The 10-year gilt now yields 4.67%, up from 4.57% on Tuesday. The 30-year is now at 5.5%, rising from 5.4% in the middle of the week.

If the threat of stagflation continues to grow, then yields will likely keep rising on gilts and other bonds.