JP’s Journal: When will rates peak – redux

Well, that was quite a few days in sterling bond markets. Last week I wrote about how central banks had lost their compass and were becoming ‘data watchers.’ This week I am reflecting on a dreadful set of UK inflation data and, again, the implications for interest rates.

Nasty surprise on inflation

Let’s recap. There was an expectation that April inflation would fall sharply, reflecting lower energy prices. Whilst the headline Consumer Price Inflation (CPI) rate did fall, from 10.1% to 8.7%, it was nowhere near as big as forecast. The sting in the tail was the rise in core inflation which hit 6.8%, a rise from 6.2%. Where were the surprises? Recreation and culture saw ‘widespread’ inflation whilst telecommunications providers (mobiles and broadband) put through eye-watering price increases. A key concern for the Bank of England (BoE) now is that inflation becomes embedded in consumer psychology.

In short, the outlook for interest rates has got worse. If we look at market levels, we can see that a Bank Rate of around 5.5% is priced in for year end, compared with just above 4.75% only a week ago. Pushing this out a bit more we can see that the first rate cut is now expected in late Q1 2024 and that a Bank Rate of 5.25% is still on the cards for mid next year.

Given these inflation impulses, and current market expectations, it is unlikely that the BoE can resist the pressure to put up rates again. Not to do so risks undermining their credibility, both domestically and internationally. The aftermath of last year’s mini budget is a cautionary tale of what happens when credibility is lost.

Yields higher – view changing?

The reaction to the inflation data in the UK government bond market was severe. Over the week, 10-year yields rose from 4% to above 4.3% and, with impeccably bad timing, the BoE indicated a faster unwind of quantitative easing – a great example of being topped and tailed. In my opinion, we are in overshoot territory for gilt yields – with medium rates above our view of fair value. This is reflected in our UK government bond strategies going long duration against benchmark. This is a real departure for us. For most of the last 15 years we have tacked to be short duration against indices. At times this has been painful but, as can be seen in our longer-term record, the approach taken by Craig Inches and his team has been vindicated. It could be time for change though. Not only on duration, but also on our view of UK government bonds relative to other global markets. With 10-year gilt yields at the same level as Greek bonds, I think it is time to be more constructive on the former.

But surely, with inflation at 8% and gilt yields below 5% there is still a big hit to holding fixed rate debt? It may sound like a broken record, but I believe that disinflation is about to accelerate. In my view, the upside surprise in inflation reflects some temporary factors and the fall in energy price inflation still has some way to go. The emerging issue is that higher business costs and mortgage rates are going to impact investment and consumer spending. The bottom line is that it hardens my view that we are heading to recession. If that is going to happen it makes sense to lock into some of these longer-term yields.

Looking beyond gilts

Talking of recession, Germany recorded two successive quarters of output contraction. The economy is now estimated to be 0.5% smaller than it was before Covid – the same outcome as the UK. March saw falls in German industrial production, retail sales and construction and although the Purchasing Managers’ Index showed a better outlook, particularly in services, there are some major headwinds arising from lower export demand. Overall, the pattern in the eurozone is familiar. Inflation is proving sticky, central banks are warning about higher interest rates and markets are anticipating further hikes whilst the outlook for growth deteriorates. The rise in government yields has been much less severe in the eurozone than in the UK – but we may see this gap closing in the next few weeks. Nevertheless, with 10-year German yields above 2.5% it means that these rates have gone up 1.5% in the last 12 months.

Credit markets continued to trade sidewards – from a spread perspective. However, with the rise in government yields, sterling investment grade yields are now approaching 6%, compared with 1.6% just two years ago. In high yield spreads have narrowed, although yields remain attractive. One area we will need to remain vigilant is real estate. The rise in interest costs has already impacted valuations and I see more pressure coming. In our investment grade portfolios, most of the real estate lending is done on a secured basis – this does not stop defaults, but it mitigates the impact. I have a hunch that pressures in the real estate sector will cause angst in private credit, where money has been awash in recent years.

So, a change in view on UK government bonds. This seems pretty seismic given our long-term stance. However, as circumstances change so will our positioning. If inflation remains high and interest rates remain elevated, it is cash that will be king.

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