Bond Watch: Bank of England’s dire inflation forecast may be too optimistic

Sam Benstead runs through the most important news stories of the week for bond investors.

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 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.

Here’s what you need to know this week.

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Another shocking inflation number – but the worst is still to come

Inflation figures this week showed that prices rose 10.1% from July 2021 to July 2022 (up from 9.4% in June), driven by higher food prices. Inflation in Britain is now higher than any G7 country, but with energy costs set to soar from October, when the price cap could nearly double before rising again in January, the worst is yet to come.

While the Bank of England expects inflation to peak early next year at around 13%, not everyone agrees. Deutsche Bank thinks it will peak at around 16%, while think-tank The Resolution Foundation expects 15%.

Previous peaks had been forecast for this summer, then autumn, and now the first few months of next year.

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In reaction to the higher-than-expected inflation reading for July, bonds sold off. Short-dated UK government bonds (gilts), which move in line with interest rates expectations, saw the most dramatic price change, as investors repositioned for higher interest rates in the UK.

The two-year gilt now yields 2.4%, compared with 2% ahead of July’s  inflation data. Bond prices and yields have an inverse relationship.

Capital Economics, a consultancy, expects a 50 basis points hike in mid-September now, rather than the 25 basis points that markets expected before.

Interest rates could double by February – despite recession

The significance of the inflation data is that interest rates need to move higher to control prices, even if this comes at the expense of the economy.

David Dowsett, global head of investments at GAM Investments, sees interest rates doubling from 1.75% today to 3.5% by February.

Dowsett said: “The higher-than-expected inflation release, combined with the prospect of higher inflation to come in the autumn, accentuates the policy challenge for the Bank of England. Official interest rates are set to double by February, despite the threat of an impending recession.”

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This is bad news for the economy, and particularly for those who are close to re-mortgaging. The house rush that began in the summer of 2020 led to huge numbers of people taking out two-year fixed mortgages. When they come to get a new deal, they will be in for a nasty shock.

The average two-year fixed deal now has an interest rate of just under 4%, compared with around 2% a year ago, according to the Moneyfacts, a financial data firm.

The other consequence of rising rates amid an economic crisis, according to Dowsett, is that pressure is mounting on the independence of the Bank of England. For politicians, saving jobs could be more important than hitting the 2% inflation target.

If the Bank lost its independence, this would be extremely worrying for the inflation outlook and bad news for bonds.