Global bond markets got off to a rocky start last week with yields continuing their rise from early December lows. The reason is not hard to fathom – inflation.
If we look at a recent survey of 32 economists only four believe that the high in UK Consumer Price Index (CPI) inflation this year will be below 5.5%, with 19 predicting a peak above 6%. The main culprit is higher energy costs, a global phenomenon that has impacted the UK more severely than other economies. It looks quite likely that the UK Energy Price Cap will increase significantly from its current £1277 – perhaps by as much as £700 without government intervention. The call for a VAT exemption on fuel bills has been rejected by the Prime Minister, despite his previous backing for such a move in the Brexit campaign.
This will put the Bank of England (BoE) in a tricky position. It is likely that their recently revised inflation forecast is already out of date and makes the chances of UK Bank Rate rising to 0.5% in February more likely. This will trigger an end to further investment of quantitative easing (QE) maturity proceeds back into the gilt market – there is some wriggle room here but the BoE will be keen to maintain transparency and stick to its messaging, I think.
The BoE is also in trouble with its GDP forecasts. The squeeze on real disposable income, brought about by higher prices, proposed increases in National Insurance and rising energy costs, coupled with the labour market disruption of Omicron, suggest to me that the UK will not grow by 5% in 2022. I remain sceptical of the argument that consumers will unleash their unplanned savings, accumulated during Covid, in a splurge of spending. A lot of the saving has been done by those with a lower propensity to consume i.e., the relatively well-off. I don’t see spending habits changing much.
Markets, as usual, have run ahead of policy makers. If we look at the indicated path of Bank Rate, it shows four hikes of 25 bps priced in for over the next 12 months. The good news is that markets are not pricing in much further tightening from there. The bad news is that, even when rates rise in line with expectation, there is a nasty habit of expectations moving higher.
I remain of the view that global government yields will rise during 2022. Although quite a bit of the heavy lifting, at short and medium maturities, has already been done in late 2021, I remain bearish on long bonds. My preference is still to keep duration below benchmark, favouring short duration and income orientated strategies.
Government bonds and cash
Three-month UK money is approaching 0.5%, an indication that the market is betting on a February rate rise, and this has rippled through the government curve with two-year and five-year yields up at 0.8% and 1% respectively. Over the week medium and long-dated yields showed a similar pattern; 10-year rates hardened to 1.2% whilst ultra-long yields ended above 1.1%, almost double the yield seen four weeks ago.
In The US, the jobs data provided a mixed picture. Headline payrolls disappointed on the downside at 199k compared to consensus expectations of 450k. However, there were positive revisions to recent payroll data and the unemployment rate fell more than expected to 3.9%; this is quickly closing in on the rate seen pre-pandemic of around 3.5%. In addition, average hourly earnings were strong and the underemployment rate was revised lower. Against this background US rates backed up, with the 10-year yield ending at 1.8%, the highest rate since the onset of the Covid outbreak. Implied inflation weakened a bit over the week as US real yields moved less negative.
In the euro area, German 10-year yields are close to zero, after being -0.4% in the week before Christmas. Italy was a casualty from the sell-off with yields now around 1.2%, a widening of nearly 50 bps over German yields since February of last year.
Sterling issuance picked up, as expected, in the first week of the year. We got involved in several of these e.g., senior Lloyds Bank, New York Life and Met Life and we were able to add, through the secondary market, to some secured bonds we like. Our cashflows remain relatively robust, particularly in our ethical and sustainable strategies, so issuance has been timely.
Investment grade spreads tightened on the week, although not enough to offset higher government bond yields. High yield reversed the trend seen at the end of last year with spreads wider, although still quite a bit tighter than in November 2021.
At these valuation levels my mantra still holds – investors generally get paid to take credit risk but make sure you spread risk and get close to the assets of the issuer – especially in cases where the market does not recognise the benefits of security.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.