Bond Watch: inflation down, interest rates up

Sam Benstead breaks down the latest news affecting 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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Inflation keeps falling

Inflation in Britain and the US continued to fall in November. Prices in the UK eased to 10.7% year-over-year growth, compared with 10.9% in October. In the US, they rose 7.1% for the year, down from 7.7% in October.

Core inflation, which strips out volatile items such as food and energy, was 6.3% in the UK and 6% in the US.

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Falling inflation is great news for investors. It means that central banks can slow down their interest rate hikes, and potentially cut rates next year to support the economy if inflation is tamed. Stocks and bonds like falling interest rates, and both asset classes have rallied over the past couple of months on the positive inflation outlook.

While the direction of inflation is encouraging, prices are still rising at an extremely damaging rate for consumers and businesses. The economic slowdown next year could be very painful, with unemployment rising, even if the stock and bond markets perform better than this year.

Bank of England raises interest rates

Interest rates in Britain rose from 3% to 3.5% this week as the Bank of England continued its fight against inflation.

The 0.5 percentage point increase came after a 0.75 point jump in the November meeting and was largely expected by markets, meaning the stock and bond market reaction was minimal.

Vivek Paul, UK chief investment strategist at the BlackRock Investment Institute, said the Bank of England’s latest move made it the most pronounced hiking cycle since the late 1980s and signalled that the “great moderation” period of low inflation and economic uncertainty for a generation had ended.  

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The investment group is not positive on developed market equities, including the UK, as it expects coming economic difficulties to hurt valuations.

Paul said: “Analysts’ expectations of positive earnings growth in 2023 are too optimistic. We also advocate rethinking bonds in portfolios next year. The good news is yields are higher, making key areas of fixed income more attractive, e.g. global investment-grade credit and US inflation-linked bonds.”

And so does the US Federal Reserve

The US central bank eased its interest-rate hiking plan this week, implementing a 0.5 percentage point increase following four 0.75 point rises in a row. US interest rates are now 4.25% to 4.5%, up from just 0.25% at the start of the year.

While a less aggressive hike, Federal Reserve boss Jerome Powell warned that “it will take substantially more evidence to give confidence that inflation is on a sustained downward path”, despite lower inflation numbers in the US.

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Central bank members, on their “dot plot” charts, which map out interest rate expectations, said they expected US rates to be 5.1% at the end of next year, suggesting 0.75 points of rate rises yet to come.

Seema Shah, chief global strategist at Principal Asset Management, said: “Yesterday’s promising inflation data doesn’t seem to have swayed the Fed’s hawkish intent at all. Not only do they see rates above 5% next year but, unless they are planning to take rates towards 6%, the dot plot indicates no rate cuts in 2023. There also seems to be a broad acceptance of inflation above the 2% target at the end of next year - imagine how high they would need to take rates if they wanted to score a bullseye!”