Our new weekly 'Bond Watch’ series highlights the most important news for DIY investors from the world of fixed income.
Welcome to interactive investor’s new weekly 'Bond Watch’ series, covering the latest market and economic news – as well as analysis – that is relevant to fixed income 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.
Rate hikes galore
Central banks stepped up their interest hikes in an attempt to tame rampant inflation. Last week, the US Federal Reserve raised interest rates 0.75 percentage points to between 2.25% and 2.50%, while the Bank of England (BoE) this week raised rates 0.5 percentage points to 1.75%.
These were serious moves, with the BoE’s hike the biggest since 1995 and the Fed’s 0.75 percentage point hike the second of that size in a row. July’s move was the first of that magnitude since 1994. However, given that investors saw these increases coming, the market reaction was subdued.
There are likely more hikes to come. The BoE Monetary Policy Committee members voted eight to one in favour of the decision, showing strong support for higher rates. Consultancy Capital Economics' chief UK economist Paul Dales expects rates in the UK to hit 3% to tackle inflation.
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Dire economic outlook
While the interest rate decision from the BoE did not come as a surprise, its reading of the economy did.
The Bank said that inflation would likely peak at 13% later this year due to higher energy prices, before returning to its 2% target in around two years' time. It also predicted five consecutive quarters of negative GDP growth, starting in Q4 this year.
It said: “Underlying GDP growth has slowed and the UK economy is forecast to enter recession later this year. Output is projected to fall in each quarter from Q4 2022 to Q4 2023. Growth thereafter is very weak by historical standards.”
This is a very negative outlook for the economy, but that’s not necessarily bad for bonds.
Bond investors unfazed
In the past month, all bond sectors have been positive, and most were over the past week as well. Yields have therefore fallen: the US 10-year Treasury Bond has fallen from a 3% yield last month to 2.7% today, while the 10-year UK Gilt has moved from about 2.2% to 1.9%.
In fact, investors read the comments from central banks around their rates hikes as “dovish” (bearish), as they suggested they were worried about the economy, which would then lead to slower interest rate hikes.
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The BoE’s decision yesterday, for bond investor Gabriele Foàm, of Algebris Investments, was a dovish development.
Foàm said: “It meant less commitment to future hikes and higher probability of a dovish approach should data turn more negative.
“The base case remains for further hikes, with markets pricing a terminal rate just below 3%, to be reached in March 2023. Rate cuts are priced for the remainder of 2023. In the short term, we see another 0.5% hike as possible (but not a given), with a sequence of 0.25% rises after that.”
So, as is often the case in markets, bad news may mean good news for bond investors, so long as it leads to fewer interest rate increases.
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