Bond Watch: why inflation rise is nothing to worry about

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 data this week showed annual July prices rises of 2.2% in the UK and 2.9% in the US. This compares with 2% and 3% in June.

While the US inflation print dropped below 3% for the first time since early 2021, the UK number edged up slightly.

But the increase in UK inflation was less than the 2.3% jump expected, which was welcomed by bond markets, causing gilt yields to drop.

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On the UK numbers, Deutsche Bank said: “All in all, despite the slight rise in headline inflation, underlying inflation metrics point to further progress in getting inflation sustainably back to target.”

The bank now forecasts that inflation will average 2.5% over 2024, and 2.3% in 2025. It says this week’s inflation figures would be encouraging to the Bank of England, particularly as a June wage report highlighted firming downward pressure in pay growth.

Inflation back around the central bank’s target is good news for bond prices as it allows for interest rate cuts with less fear that they will cause inflation to jump again.

Are bonds back as a diversifier?

A stock market wobble in early August was good news for bonds.

Linked to weak economic data in the US, a flash crash in Japanese shares due to interest rate rising and the yen strengthening, and worries that tech giants are over-investing in artificial intelligence, stock markets fell and bond markets rose.

An index of UK corporate bonds jumped 1.5% in the last week of July, as global shares dropped about 4%. Demand for gilts and US government bonds also rose, causing yields to fall, which is a result of rising prices.

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The market events showed why investors own bonds: diversification from equities, as well as attractive yields.

This is because in the event of a recession, central banks can step in to cut interest rates. Some bonds, like those issued by the UK and US governments, are also safe-haven assets and tend to rise in value when investors are worried.

Dan Ivascyn, chief investment officer at PIMCO, says: “Today our fixed-income valuations are much more attractive, both in relative terms, and absolute terms. So we think not only will bonds provide attractive returns in the base case, they should begin to exhibit those diversified qualities that have really strengthened the case for them to be in an investor’s portfolio.”