Bond Watch: Rishi Sunak calms markets after Boris Johnson scare

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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Rishi Sunak is popular with the bond market

Bond markets cheered the appointment of prime minister Rishi Sunak. The yield on the 10-year UK government bond has fallen from 4.1%, when it looked likely that Boris Johnson would become a credible challenger, to 3.7% after Sunak’s appointment. Bond yields move inversely to price.

Sunak has kept Jeremy Hunt on as chancellor and is widely seen as fiscally conservative. In his run to become prime minister in the summer, he pushed for higher taxes to control inflation and balance the budget, which was the opposite of Liz Truss’ approach that ended in bond market panic.

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Sunak also warned that Truss’ spending plans would spook markets and cause borrowing costs to rise, which is of course what happened. This suggests that he understands financial markets and their importance.

After the U-turns on fiscal policy, UK government debt now yields less than US government debt and yields have fallen back to a similar trend line to other developed economies.  

What happens when inflation is greater than 8%?

Economists and investors expect inflation to fall next year and be back towards target (2%) by 2024, but history points to a different outcome.

Deutsche Bank looked at 100 years of economic data to find clues about what happens following a period of more than 8% inflation.

The evidence showed that once inflation spikes above 8%, it takes around two years to fall beneath 6%, and normally settles around that level for up to five years after the initial 8% shock.

However, the current consensus expects inflation to be back below 3% in just two years, according to Deutsche Bank.

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Jim Reid, head of global fundamental credit strategy at the firm, said: “This is far from impossible, but it would be around the 25th percentile (one in four) of observations through history.”

If inflation is higher for longer, then that’s bad news for bonds. Not only will the “real” income on offer fall, but central banks will have to keep rates higher for longer, which would be bad news for bond prices.

Bonds are back on the menu

The rise in bond yields has not gone unnoticed by professional and DIY investors, with money flowing once again into bond funds as investor hunt for income.

Investment Association (IA) data for August, the latest available, showed that overall investors took £2.6 billion out of funds, which marks the seventh month of outflows this year, but £1 billion flowed into bond funds.

Numbers from data group Morningstar this week showed that €8.1 billion (£7 billion) flowed into bonds in the European exchange-traded funds market in the third quarter of the year, compared with €3.2 billion in the second quarter, marking a €5 billion increase.

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This comes as €7.9 billion was withdrawn from the European ETF market in total as investors rushed to raise cash and bet that market falls would continue.

Bank of America’s latest survey of professional investors showed that they are the most bullish on bond yields since November 2008, with 38% expecting lower long-term rates in the next 12 months.

Finally, interactive investor customers have reacted to higher yields by buying bonds directly, with bond purchases up 700% in the first two weeks of October compared with 2021. Flows into bond funds are also increasing.