Bond Watch: UK inflation could be 2% by the spring
Sam Benstead breaks down the latest news affecting bond investors.
5th January 2024 10:41
by Sam Benstead from interactive investor
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Welcome to interactive investor’s ‘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.
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Here’s what you need to know this week.
How quickly will inflation fall in 2024?
The Bank of England may be far too pessimistic on UK inflation. When announcing its November interest rate decision to hold the base rate at 5.25%, it said that it expected inflation to hit its 2% target around the end of 2025.
However, with the consumer price index now at 3.9% for the year to November, some economists believe that the target will be reached far sooner – even within the next five months.
One of those is Deutsche Bank chief UK economist Sanjay Raja, who recently gave “eight reasons to be optimistic” about the UK economy, with one being that CPI inflation could be as low as 2% by May this year, with inflation averaging 2.7% for 2024.
This compares with 2.4% annual UK inflation for the past 25 years, according to data from Allianz Global Investors.
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Bloomberg’s economists are also far more optimistic than the Bank of England. They think inflation will hit 2% by the spring, with rate cuts following in May, and the bank rate finishing the year at 4%.
Raja also expects rate cuts to begin in May.
If inflation falls far faster than the Bank of England expects this could lead to sooner-than-expected interest rate cuts, which would be good news for bond prices. Lower inflation also increases the “real” return of bonds, which takes into account rises in prices.
Bonds start the year on the back foot
Bond yields have risen in the first trading week of 2024 due to investors dialling down bets for rate cuts.
The yield on the 10-year UK government bond has risen from 3.5% to 3.7%. Rising yields are a result of falling bond prices.
US bonds followed the same trajectory, with yields on the 10-year Treasury rising from 3.9% to 4%.
Investors are reining in their optimism after a very strong end to 2023, where bond yields fell and stocks rose substantially as markets began to price in interest rate cuts in 2024.
The rally saw US 10-year bond yields drop from 5% to below 4%, a big move that caught many investors off guard, while UK 10-year debt fell from around 4.5% to 3.5% over the past two months of 2023.
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Jim Reid, a strategist at Deutsche Bank, says that the minutes of the December Federal Reserve revealed some new clues about future interest rates.
He said they did not offer any pointers to imminent Federal Reserve easing, with little in the way of a discussion of rate cuts that Jerome Powell had alluded to in the press conference.
Reid says that there was also some pushback on the recent easing of financial conditions at the meeting, with the Fed suggesting that an easing in financial conditions “beyond what is appropriate” could make it more difficult for the central bank to reach its inflation goal.
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