Bond Watch: bond yields rise despite inflation drop off

Sam Benstead breaks down the latest news affecting bond investors and income seekers. 

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. 

UK inflation drops but remains high

Both the UK and US released inflation figures in a big week for bond markets. Inflation is the key measure central banks look at when setting interest rates.  

In the UK, inflation for January came in below market expectations, at 10.1% for the year, after printing 10.5% in December 2022.  

A combination of easing core goods prices, falling petrol prices, and softening non-core services prices (particularly travel and package holidays) was behind the inflation slowdown 

Deutsche Bank expects the Bank of England to raise rates one more time, by 0.25 percentage points to 4.25%, before pausing its rate hikes. Its inflation forecast puts price rises at 4.1% by the end of the year.  

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“Some stickiness in services inflation remains likely, in our view – especially with wage settlements remaining well above rates consistent with the Bank's 2% mandate,” the bank said.  

Despite the inflation slow down, bond yields, which move inversely to price, have risen this week. Investors can now get a 3.5% annual return from lending money to the UK government for 10 years compared with 3.2% one week ago. This reflects market views that interest rates may have to be higher for longer.  

US inflation slowdown slows

Inflation in the US has been falling much faster than in the UK. January’s figure came in at 6.4%, down slightly from 6.5% in December, but markets are beginning to price in higher inflation and interest rates for longer than previously expected. 

A strong jobs market and slowing disinflation have persuaded Deutsche Bank to forecast a higher peak in interest rates in the US. 

The bank now expects rates to peak at 5.6% (from 4.75% today), rather than 5.1% before the latest economic data was released this week. 

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A higher terminal (peak) rate is bad news for bond markets, as investors sell bonds when they factor in more rate rises. 

Bond yields have therefore been rising in the US, especially on short maturity bonds, which react closely to short-term interest rates. Investors can now lock in 5% returns for lending to the US government for a year, and 4% for five years. The US 10-year bond currently yields 3.8%.  

Lower-rated bonds outperform this year 

Despite the shifting sentiment in markets this week, higher-risk bonds have performed best so far this year, as the broad market narrative so far in 2023 has been that central banks will not raise rates as high as anticipated last year, and inflation will keep falling.   

Invesco, the fund manager, noted that January was the strongest month-ever for net inflows into fixed income exchange-trade funds (ETFs), with investors generally increasing risk in their bond portfolios.  

Paul Syms, head of Europe, Middle East and Africa ETF fixed-income product management at Invesco, said: “Confidence grew that central banks would slow the pace of rate hikes in coming months which, with peak rates potentially now in sight, could lead to the soft landing that would be positive for many asset classes.” 

The best bond sectors so far this year, on a total return basis to 15 February 2023, are: Global Emerging Markets (5.6%); Sterling Corporate Bond (3.4%); and Sterling High Yield (3.4%).