Bond Watch: markets cheer steep UK inflation drop

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. 

Bonds rally after big inflation drop

Bond markets cheered lower than expected UK inflation this week, as prices rose just 3.9% in the year to November, compared with expectations of a 4.4% annual increase. 

Lower inflation gives the Bank of England more freedom to cut interest rates, and so markets are now pricing in a first interest rate cut as early as May 2024. Expectations are currently for 1.38 percentage points of cuts over the next 12 months, according to the Financial Times.  

UK inflation now looks like much less of an outlier compared with the UK and Europe, so in response investors bought government bonds, sending yields on the 10-year gilt down from 3.8% to 3.5% over the course of the week.

Falling fuel costs was the biggest contributor to the fall in inflation in the year to November. Nevertheless, it is important to remember that prices are still rising and the inflation rate is nearly double the 2% Bank of England target. 

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Over a month, the 10-year gilt yield has dropped from 4.2% to 3.5%. Falling yields are a result of rising bond prices. 

George Lagarias, chief economist at accountants Mazars, said transport prices dropping will offer a real festive gift to consumers, boosting households' real income.  

He said: “This can significantly contribute to households' real incomes and boost consumption. Nevertheless, we feel that the Bank of England is justified to remain vigilant against a rebound in prices. The geopolitical environment is as tense as ever, and energy prices are currently near the lowest level they have been for a long time, which means that a rebound on the upside is likely in the next few months.” 

Lagarias also notes that if Chinese authorities succeed in stabilising their economy, then the world’s second-biggest economy could stop exporting deflation to the world and prices for western consumers could rise again. 

“Despite UK inflation coming down faster than anticipated, we would expect credit conditions to remain tight in the next few months,” he said.  

Are bond markets getting ahead of themselves? 

Disinflation around the world, which has come quicker than many experts anticipated, has led to a big rally in bond prices. 

While in the summer the consensus was of higher interest rates and inflation for longer, now the expectation is that interest rates will fall significantly next year. 

The Financial Times reports that yields are already lower than where many experts thought they would be by the end of 2024. 

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It said that the median forecast in a November survey of more than 50 analysts for Bloomberg predicted that 10-year US Treasury yields would fall to 4% by the end of 2024.  

But yields are already below that, at 3.9%, following a big stock and bond market rally after the US central bank’s December meeting where chair Jerome Powell revealed that he was ready to cut interest rates next year.  

Could this mean that much of the good news for bonds has already arrived? It all depends on what happens to inflation, and if the 2% target is in reach by the end of 2024, then bond markets should continue to rally.