Bond Watch: inflation data sparks bonds rally

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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Inflation falls in the UK...

Inflation fell unexpectedly in the UK this week, to 2.5% in the year to December. This was below the 2.6% expected by economists and the 2.6% reading for November.

Core inflation, which strips out volatile food and energy costs, came in at 3.2%, down from 3.5% in November – a bigger drop than the 3.4% expected.

The surprise fall offered much-needed respite for the government after a tumultuous week for gilts.

The Bank of England uses inflation figures to set its interest rate. Signs of inflation easing led to investors pricing in a greater likelihood of an interest rate cut in a month’s time.

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As a result, gilt yields fell (and prices rose). The 10-year gilt now (as at the morning of 17 January) yields 4.64%, down from 4.85% at the start of the week.

Gabriella Dickens, an economist at AXA Investment Managers, said: “Today’s inflation data give both the Bank of England and the chancellor some room to breathe following the recent sell-off in the bond market and concerns over stubborn services inflation.”

Nonetheless, markets still expect the Bank of England to cut just twice this year, notes Dickens.

However, her view is that there could be four 0.25 point interest rate cuts this year, one per quarter, leaving Bank Rate at 3.75% by the end of 2025.

She says: “While the headline inflation rate will edge higher this year, peaking at just under 3% in the third quarter, we do not think the UK has an inherent inflation problem: a looser labour market and weaker activity mean the risks of an undershoot are rising over the medium term.”

...but rises in the US

While inflation in the UK dropped slightly, data this week showed that it rose in the US.

Inflation for the year to December was 2.9%, up from 2.7% in November. The biggest causes of the inflation spike were rising energy and egg prices.

While headline inflation rose, core inflation rose 3.2%, which was lower than expected. This reading was welcome by markets, sending US government bond yields down a similar amount to in the UK.

Overall, inflation readings in the UK and US were slightly better than expected, which prompted a stock and bond market rally.  

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Tina Adatia, head of fixed-income client portfolio management at Goldman Sachs Asset Management, said: “After recent red-hot data, today’s softer than expected core CPI reading should help cool fears of a re-acceleration in inflation.

“While today’s release is likely insufficient to put a January rate cut back on the table, it strengthens the case that the Federal Reserve’s cutting cycle has not yet run its course. With labour market data remaining robust, however, the Federal Reserve has scope to be patient and more good inflation data will be required for the Fed to deliver further easing.”