Bond Watch: central banks in sync as rate rises continue

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

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.

Here’s what you need to know this week.

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Rates rise 0.75 percentage points in the US and UK

Central bankers are in sync on either side of the Atlantic, with US and UK interest rates increasing 0.75 percentage points this week.

The rate hikes were expected by markets. Therefore, it was no surprise that stock and bond markets were calm following the decisions. Interest rates are now 3% in the UK, and 3.75% to 4% in America.

Comments from central bank bosses Jerome Powell and Andrew Bailey added some colour about what investors should expect from interest rate policy.

Powell warned that there was “some way to go” for rate hikes and the “ultimate level of interest rates will be higher than expected”.

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However, he hinted that less aggressive rate rises may begin in December, and rate decisions would take into account the lag before monetary policy impacts economic data. Markets now expect rates in the US to peak at about 5% in May 2023.

In the UK, Bailey said that the labour market remained tight and there had been “continuing signs of firmer inflation in domestic prices and wages”.

This could mean inflation is becoming more embedded. Bailey cautioned that further increases would likely be needed, but given the change in UK government policy, they would not have to rise to as much as 5.25% as markets had previously expected.

Vivek Paul, UK chief investment strategist at the BlackRock Investment Institute, said the Bank of England has tightened monetary conditions even when recognising that the UK is already heading towards a recession.

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Paul said: “While the mini-budget may be no more, its legacy persists in one key manner: markets have reminded us that investors care about fiscal credibility, and with the government’s plans to plug the fiscal deficit yet to be finalised, the Monetary Policy Committee may still be worried about the inflationary implications of unsustainable fiscal policy. Even though evidence of the damage to growth from higher rates is becoming clear, today’s hike is unlikely to be the last.”

Brazilian bonds are ‘sustainable’ again

Elsewhere, Danish fund group Nordea Asset Management has lifted its ban on Brazilian government bonds following the election of Lula da Silva as president.

Lula, as he is known, has pledged to halt the destruction of the Amazon rainforest. His predecessor Jair Bolsonaro took a lax approach to conservationism, allowing much of the forest to burn so farmers could use the land. 

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This caused Nordea, which is a leader in sustainable investing, to boycott Brazilian government bonds in its emerging market debt funds in 2019.

Thede Rüst, head of emerging markets debt at Nordea Asset Management, said: “Based on policy announcements from the president-elect – including the expected return of Marina Silva in a central policymaking role, and the effective concession of the election by the outgoing president – our emerging markets debt team at Nordea Asset Management has decided to lift the quarantine on Brazilian government bonds.”

Environmental, social and governance (ESG) investing can run into problems in the bond market, where governments can spend their money as they please and pursue their own environmental and social agendas.

Yet another sign that investors are worried

And finally, the yield curve has inverted. The yield curve plots the yield of bonds with different maturity dates on a chart. Generally, longer-dated bonds have higher yields to account for the greater risk of lending for a longer period. This causes the yield curve to slope from bottom left to top right.

An inversion occurs when shorter-dated bonds yield more than longer-dated ones. This is happening today in the US government bond market as investors expect interest rates to rise in the short term but then fall back as the economy slows and inflation resides, which will lead to rates coming down again.

The US two-year, one-year and six-month US Treasury bonds currently yield more than the 10-year Treasury bond. The 10-year US Treasury bond yields around 4%, while the two-year is at 4.5%.

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Jim Reid, head of global fundamental credit strategy at Deutsche Bank, says that yield curve inversions are an important indicator to watch.

“I’ve kept my strong faith in the yield curve as I think the reason it works is through influencing behaviour and animal spirits. I therefore care less about why it inverts, simply that it does.

“If I offered you, say, 4.5% on two-year Treasuries, or gave you the option of taking interest rate risk at around a 4% yield at the long end, or a 1.72% dividend on the S&P 500, the front end (two-year bond) is surely very competitive.

“You can extend this analysis to decision-making throughout the economy. So, in my opinion, animal spirits slowly drain as the yield curve flattens and arguably get even more intense as it inverts.”