Benstead on Bonds: are we entering a new inflationary period?

Two big political changes in the United Kingdom and United States have played a role in pushing up bond yields, indicating that investors think that interest rates and inflation could be higher for longer.

The 10-year US and UK government bonds shot up to around 4.5% in the middle of the month, but are now at about 4.3%, similar to where they started in November. This compares with yields of less than 4% at the start of the year. Bond yields rise when prices fall.

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The election of Donald Trump as president has sparked concerns about inflation, with his “America First” agenda and tariffs expected to increase the costs of goods.

Fund manager BlackRock said Trump’s win “signals a big US policy shift” and could mean higher inflation.

Its Investment Institute says: “On trade, Trump has proposed a wide range of tariffs, including 60% on China and 10-20% universal tariffs. He will likely make this an early priority, yet implementation is uncertain.

“This protectionist stance could reinforce geopolitical and economic fragmentation, a structural factor we see keeping inflation higher in the medium term. A reduction in legal immigration could impact the labour market.”

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Since the election, Trump has said that he will hit China, Canada and Mexico with tariffs on his first day in office.

Meanwhile, in the UK, Chancellor Rachel Reeves has increased employers’ National Insurance contributions, hoping to raise more than £20 billion. The worry is that this will lead to companies increasing prices to keep their profits intact.

Deutsche Bank estimates that the tax hike will start feeding through into prices in January next year, increasing CPI inflation by 0.3 percentage points. It now thinks UK inflation will be 2.9% in 2025 and 2.5% on average in 2024, but will return to the 2% target in 2026.

If predictions for higher inflation come to pass, this would not be good news for bond investors.

This is because central banks would be more reluctant to cut interest rates, which drive up bond prices. Moreover, higher inflation means the “real” or inflation-adjusted returns from bonds would be lower, as bonds pay a fixed coupon.

Will inflation really rise?

Some investors think the market has overreacted and, particularly in the US, the outcome will not be as inflationary as expected.

Harry Richards, who manages the ii Super 60-rated Jupiter Strategic Bond fund, is one them. He told me that there are some important factors to think about that may help to keep a cap on inflation relative to expectations or fears.

Richards notes that inflation was one of the key reasons the Democrats lost the election. Therefore, he believes that Trump is unlikely to actively drive inflation higher. Coupled with the nomination of hedge fund manager Scott Bessent as Treasury Secretary, economic policy could reassure investors that the new administration will not lead to a significant rise in inflation.

Richards said: “The administration will want to avoid ‘losing the long end of the bond market’ (seeing yields rise dramatically) as any disorderly move ultimately leads to a swift negative feedback loop into the equity market, which Trump views as a litmus test for his success.”

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I think he’s right. Trump does link his political performance to the growth of the stock market, and high inflation and rising interest rates, as we saw in 2022, was bad news for stocks and bonds. If inflation and the stock market are performing poorly, then he could lose the support of his party and the public.

But will his policies lead to this outcome? There is a case to be made that Trump could actually reduce inflation in the US and globally.

One reason is that Trump has made ending the Russia-Ukraine war quickly a key goal. Richards says this would relieve energy and grain prices. Increasing US oil supply, which Bessent is keen to do, would also keep US inflationary pressures down.

Longer term, Trump wants to increase efficiency in the US government by cutting costs. He has put Elon Musk and entrepreneur and presidential candidate Vivek Ramaswamy in charge of the newly created Department of Government Efficiency (DOGE). Musk has said he could cut up to $2 trillion (£1.6 trillion) annually from the US budget.

Richards says this could be good news for inflation and falling interest rates.

“While the unemployment rate and broader labour market have not been the key driver of recent moves in global government bond yields, we have high conviction that is what will matter eventually and that the Federal Reserve will be forced to react. One of the most deflationary forces is a rise in the unemployment rate, as it acts to halt spending with relative immediacy,” he said.

The impact of tariffs could also be less inflationary than expected over the long term, although short term they look set to lead to higher prices.

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Richards’ view is that they reduce aggregate demand in the importing country (US), where the consumer is already experiencing a cost-of-living crisis. In the rest of the world, he says that it can create a significant surplus of supply and act to suppress prices. Both these factors should decrease the price of goods over the medium to long term.

So, are we entering a new inflationary era? I think what’s certain is that we are going to be in for lots of volatility with Trump in charge, which will affect inflation, as well as stock and bond markets.

But I still believe that the overall direction of prices will be back to central bank targets of 2%. This makes the 4.3% yields on US and UK government bonds attractive from an income perspective, but also from an asset allocation view, as interest rates can fall to boost bond prices if there are economic growth worries or a stock market crash.

It is also possible that Trump is talking a tough game on tariffs to strengthen his negotiating position, but will water down rates when they are implemented if he gets what he wants with regards to stopping the flow of illegal migrants and drugs into the US.