Bond Watch: rising US inflation means fewer rate cuts

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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US inflation comes in hot 

Annual inflation for March in America hit 3.5%, ahead of the 3.4% expected by economists. Higher fuel, housing and eating-out costs contributed to the increase.

Rising inflation gives the US central bank less freedom to cut interest rates. Higher interest rates for longer spells bad news for bond prices. When interest rates rise or are expected to rise or stay higher for longer, existing bond yields rise as prices fall. In response to the inflation figure, investors therefore sold bonds, sending yields higher. UK and US 10-year government bonds yield 4.2% and 4.5%. 

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Neil Birrell, chief investment officer at Premier Miton Investors, says: “The US economy is running along at quite a pace and a June rate cut looks less and less likely – July or September is the call now. The Federal Reserve has got some head scratching to do and if other central banks were waiting for the Fed to move, they have got a conundrum on their hands now.” 

What the US central bank does affects what other major developed world central banks do. Investors now expect just two rate cuts in the UK this year, while the European Central Bank (ECB) decided this week to keep rates at 4%. However, the ECB did signal that it could begin cutting rates in the summer.  

What ‘higher for longer’ rates mean for yields 

In my latest “Benstead on Bonds" column, I wrote about how an inverted yield curve means that bonds maturing soon – which are less volatile than longer maturity bonds – currently offer attractive yields. 

The yield curve plots the yields of bonds with different maturities on a chart. The shortest bonds at the beginning generally have the lowest yields, with the longer bonds at the end of the chart having the highest yields, creating a line from bottom left to top right. However, there is currently a wobbly yield curve, with some of the shortest bonds yielding more than the longest ones, and those maturing in the medium term, from three to 10 years away, yielding the least.

If interest rates stay higher for longer, this opportunity will persist for longer. Mickael Benhaim, head of fixed income investment strategy/solutions at Pictet Asset Management, thinks that the last mile of inflation will be the hardest – to get down to 2% from 3%, which may require central banks to have a higher for longer stance.

However, when interest rate cuts happen this will cause the front end of the curve to adjust, leading to a more normal-looking yield curve, according to Benhaim.   

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There are lots of high yields on offer from some of the safest parts of the bond market. Data from FE Analytics shows that abrdn Short Dated Corporate yields 5.4%, while Royal London Sustainable Short Duration Corporate Bond and M&G Short Dated Corporate yield 5.29%.   

Money market funds, which invest in bonds about to mature to achieve a “cash-like” return, also yield a lot at the moment. The top income payers are Premier Miton UK Money Market (5.77% yield); abrdn Sterling Money Market (5.5%) and Royal London Short Term Money Market (5.25%).  

These are the income yields on the portfolios – an annualised measure of the income paid out over the past 12 months.