Bond Watch: why interest rates will surpass 5% in the US

Sam Benstead breaks down the latest news affecting bond investors and income seekers.

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.

Markets price in higher US interest rates

Bond markets now expect a 50 percentage point rate rise in the US Federal Reserve’s March meeting, following comments from chair Jerome Powell this week on the need for more aggressive monetary policy.

Currently at between 4.5% and 4.75%, markets are now pricing in rates going above 5.5% by the summer, according to data firm CME Group.

Powell told politicians in Washington DC that “the ultimate level of interest rates is likely to be higher than previously anticipated”.

Traders reacted by selling short-dated bonds, which move in response to short-term interest rates. The six-month to two-year US Treasury bonds now yield more than 5%. Yields then drop on longer-dated bonds, known as an inverted yield curve, which suggests that bond investors think that interest rates will begin to fall over the medium term once inflation is under control and the US economy begins to slow.

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Economic data out of the US shows a hot labour market and economy, despite interest rates rising from less than 1% a year ago to nearly 5% today.   

Recent data has shown fewer jobless claims than expected and continued price rises in the core personal consumption expenditures index (core PCE), which excludes food and energy costs in America, making it a useful measure of sticky price changes.

Investors switch equities for bonds

Since July last year, UK-based investors have taken £5.1 billion out of equity funds and put £4.9 billion into bond funds.

The trend continued in February, with net £834 million added to bond funds.

The data, from fund administration firm Calastone, shows how investors have shifted money from stocks into bonds as yields have risen on fixed-income assets. Investors can now get 4% yields from UK gilts, and even more income from corporate bonds or riskier government bonds. This compares with gilt yields of about 1.5% just one year ago.  

Higher yields have prompted calls from fund managers that “bonds are back” – and the data shows that investors have responded positively and voted with their feet by moving money into fixed income.

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However, investors do not just get a yield when they buy a bond fund – they also expose themselves to risks that bond prices will fall. Expectations about future interest rates – which are linked to inflation and economic growth forecasts – are the most important determinate of bond prices.

If rates are expected to go higher, then bond prices tend to fall, as investors will be able to pick up higher yields from newly issued bonds. Inflation is also bad for bond prices as high prices reduce the fixed income from bonds.