Last week saw a flurry of announcements with relevance to fixed income markets. On Wednesday, UK inflation data surprised on the downside – breaking a disappointing recent sequence.
Headline Consumer Price Index fell to 6.7% and the core measure dipped to 6.2% – both comfortably lower than expectations. The largest downward contributions came from food and accommodation, partially offset by a rise in petrol and diesel prices. The view remains that headline inflation will continue to fall, despite the higher oil price, reflecting helpful base effects from electricity and gas bills (they rose a lot last October) and the downbeat growth picture which will ease pressure in the labour market. The Bank of England (BoE) will be relieved to see a moderation in service inflation – it fell from 7.4% to 6.8%, helping to counteract the concerns arising from recent pay growth numbers.
Gilts took the inflation number as an indication that the monetary policy medicine was working and 10-year yields fell from 4.4% towards 4.2%. At this point investors seemed evenly split on how the Monetary Policy Committee would respond: stick or twist? But before getting the answer the US Federal Reserve (Fed) announced ‘no change’ in rate policy, keeping the target range at 5.25% -5.5%. Whilst widely expected, markets did not like the accompanying message; the Fed’s projections still show another hike this year. Looking at what is now priced, we can see that there is no change in the expected peak but that the pace of expected rate cuts has moderated. So, if we take market pricing for rates in September next year, we are currently at 5%; at the end of June this was a shade under 4.5%. And this is reflected in the way the 10-year yield has moved, now approaching 4.5%, compared to 3.8% three months ago.
This raises the question of the terminal rate that investors are expecting for US government bonds – which looks to be 4.5%-4.8%. With 30-year real yields of 2.2%, this implies long-term US inflation of around 2.5%. That inflation rate seems sensible – so is there anything to go for in US markets? Yes, because in my view real yields look too high. What has been surprising is that the rise in long-term real yields, 80bps in six months, has not disrupted other asset classes, especially ‘growth’ equities. Either relationships have broken down (perhaps AI is the equity game changer) or there needs to be relative repricing. My view is that the rise in US real yields provides a good buying opportunity.
The final bit of the jigsaw was the BoE’s decision to hold Base Rate at 5.25%. It was a tight vote (5-4), with the majority focusing on weaker underlying growth expected through the rest of the year. Is this a skip, a more lasting pause, or the peak? Despite caution on growth, the instinct is that there is one more hike left in the tank. Although optimistic that inflation will fall more than consensus there will be challenges to that view in the next few months and if the BoE is seen to be too dovish there is a risk that the currency could sell-off, making the inflation objective harder to achieve.
The gilt market, after digesting both the Fed and BoE decisions, decided that a lower peak but a longer period above 5% was the most likely outcome. This saw the 10-year rate rise from its 4.2% low point back towards 4.35% before a late rally saw a closing yield of 4.25%. In the euro area the trend was for rising yields with German 10-year rates hitting a 12-year high. So, despite technical recessions, the stickiness of inflation is pushing up nominal yields – and just remember it was only 18 months ago that we had the madness of negative 10-year German yields.
Credit yields continued to be driven by government markets with spreads being little changed – non-gilt sterling indices anchored around at 1.3%. However, high yield spreads widened, with weakness most apparent following the Fed announcement. Overall, I expect credit markets to outperform, with excess carry being the main driver from here.
Last week also saw the UK government rowing back on policies undertaken to support our net zero commitments. To me it shows that leaders have not been upfront on the implications of climate policies. Just like the HS2 debacle, costs have not been spelled out. It is to be hoped that we have that debate now. Households and businesses will need to transition and we require long-term planning for this to be successful. But let’s be explicit that these changes will not be painless.
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