Bond Watch: will the latest interest rate hike finally cool inflation?

Sam Benstead breaks down the latest news affecting 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.

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Here’s what you need to know this week.

Interest rates hit 5% in the UK

The Bank of England raised interest rates 0.5 percentage points, to 5%, as it battles to control stubbornly high inflation.

Inflation figures this week showed that CPI remained stuck at 8.7%, but core inflation, which strips out volatile food and energy cost, increased to 7.1% from 6.8% in April.

The latest inflation reading pushed the Bank to raise 0.5 percentage points instead of 0.25 percentage points.

Pressure is building on mortgage holders due to renew their deals. The Institute of Fiscal Studies (IFS) found that around a quarter of mortgages are coming off a fixed-term deal between the end of 2022 and the end of 2023.

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The IFS points out that higher borrowing costs means on average disposable incomes will fall by 8.3%, with those aged 30 to 39 experiencing the biggest hit (almost 11%). For some, the rise will be substantially larger: almost 1.4 million – 690,000 of whom are under 40 – will see their disposable incomes fall by more than 20%, according to the IFS.

This makes a recession highly likely in the UK, but will it bring down inflation?

Neil Birrell, chief investment officer at Premier Miton Investors, says: “The fear is that this could rapidly tip the economy into a recession, but that is obviously not deemed to be as bad an outcome as the risk of ongoing elevated inflation.”

Jamie Niven, fund manager at Candriam, says the Bank’s aggressive move could help it maintain its credibility.

“Ultimately, the Bank of England may have accepted that to achieve their inflation target, a recession may well be necessary. If base rates are to remain at these levels (or indeed move to levels priced by the market of around 6%), we fully expect the consumer to be hit hard, with the housing market a particular channel for potential stresses.”

Bond market likes the Bank’s aggression

The Bank of England’s move was welcomed by the bond market, with gilt yields falling in the wake of the bigger than expected interest rate hike.

The two-year gilt, which is key to mortgage pricing and reflects expectations around short-term interest rates, fell below 5% as investors digested the hawkish stance from the Bank of England.

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Greater than expected rate hikes normally lead to rising bond yields, as investors have to price in higher borrowing costs.

However, in this case, the market view was that the Bank of England is taking inflation seriously and will do whatever it takes to bring it under control, which is ultimately good for bonds as rates will eventually be able to come down.

For some, locking in greater than 4% yields guaranteed by the government is now looking like a good deal, so long as inflation drops as predicted.