On 22 September, the Bank of England (BoE) delivered its second consecutive hike of 50bps, taking interest rates to 2.25%. Whilst the majority of the Monetary Policy Committee (MPC) voted for an increase of 50bps, three dissenters voted to hike rates by 75bps, with a single lone voice voting to increase rates by only 25bps. In addition the BoE followed through on expectations regarding the start of active bond sales (quantitative tightening), which will begin on 3 October, and equate to around £10bn of active bond sales per quarter.
Whilst the MPC signalled an ongoing willingness ‘to act forcefully’, today’s outcome failed to deliver against market expectations; going into the meeting the market was 80% priced for a larger hike of 0.75%. Gilt markets have reacted with disappointment, and yields have risen aggressively across the curve. Markets are expecting base rates to peak at 4.8% in March next year versus 2.25% today. Markets are clear in their assessment; the BoE remains behind the curve and has much work to do.
On 23 September, we expect to hear more from the Chancellor about the government’s economic growth plans, and ideas to help alleviate some of the inflationary pressures currently being experienced by businesses and consumers. How the government expects to fund this will be essential for UK government bond markets. It’s been a tough few months for bond markets, but we may not be out the woods yet.
At its most recent meeting on the 8 September, the European Central Bank (ECB) Governing council followed through on market expectations and raised its interest rates by 0.75%, its largest ever single interest rate hike. This takes its deposit rate (the rate at which it pays banks on their deposits) to 0.75%, its highest level since 2011, prior to the euro crisis.
Moreover, in the press conference, Christine Lagarde (ECB President) made it clear that more rate hikes were to come, as rates were “still so far away” from the policy rate that would get inflation back to its 2% target. The ECB was left with little choice but to make this unusually large rate hike (back in June it had signalled hikes of 25bps in July and 50bps in September, only to deliver hikes of 50bps and 75bps), given the recent inflation prints in the euro zone. This saw realised CPI top 9% in August, with the ECB revising its forecasts of inflation up to 8.1% in 2022, 5.5% in 2023 and 2.3% in 2024. There has also been calls for the ECB to begin reducing its balance sheet – essentially selling back bonds to the market that it has bought under its massive Asset Purchase Programs, used to support markets during the global pandemic.
Against this backdrop of soaring prices, there is a fear of an economic recession, as consumer demand gets squeezed, business confidence falters and investment falls. Whilst the ECB itself is not currently anticipating a recession (forecasting growth of 3.1% in 2022, 0.9% in 2023 and 1.9% in 2024), the market is taking a more downbeat view, forecasting that the ECB will have to pause its hiking cycle early in 2023 – though unlike the UK and US (who began hiking rates earlier), it is not currently pricing any interest rate cuts.
This all adds up to heightened uncertainty, which translates into volatility in markets. We continue to observe daily market moves that are large enough that these used to be more typical of the moves seen over the course of a week or more. Yields are still rising, particularly those of shorter dated bonds, and yield curves are flattening, as markets price future economic downturns, meaning longer dated bonds are less likely to have their value eroded by persistent inflation. In addition to this, the Russian Ukraine war continues to impact energy and commodity markets, bond supply (against a backdrop of reduced central bank buying) is increasing and we’re looking at a general election in Italy. Taking this into account, we favour running an underweight exposure to European bond markets, though have been using the volatility to trade tactically, taking advantage of opportunities presented by thin markets overreacting to data points or central bank commentaries.
Hot on the heels of the ECB, the US Federal Reserve (Fed) followed through on market expectations and delivered a third straight hike of 75bps at its meeting on 21 September, taking the Fed Funds rate above 3%. However, this wasn’t the full story, with a new set of FOMC participant forecasts showing that US monetary policymakers envisaging hiking another 100 – 125bps by year end, accompanied by further hikes in 2023, projecting to a median of 4.6%. This is a clear indication of the determination of the Fed to get to grips with inflation, even if that may mean that a consequence is to tip the US economy into recession – indeed, this may be a necessary step in order to prevent a wage price spiral, which is one of the things that the Fed fears most. Chairman Powell has talked about the need for clear evidence that inflation is falling back towards its 2% target and expressed a determination to keep tightening policy until the job is done, although he did also note that at some point it will become appropriate to slow the pace of hikes.
The market reaction to this messaging was for the US yield curve to flatten further, with shorter dated bonds selling off still further, taking two-year yields close to 4.1%, whilst longer dated yields from 10 years out remain closer to 3.5%. As is the often the case in global markets, other regions (with the notable exception of Japan) followed the US’s lead, and the majority of markets saw a further 10 – 15bps of flattening in the trading session immediately following the Fed’s decision.
This illustrates that whilst there may be a different blend of drivers behind the global inflation problem between regions (US is more domestically generated, whereas Europe has greater sensitivity to inflated energy prices – over which it has less control), there is a clear recognition that further tightening of monetary is necessary and the market expects that Europe, at least, is happy to follow the Fed’s lead.
Taking an active approach
This environment of rising yields has seen negative total returns for bond funds across all markets, as the market reacts to excessive inflation, far less accommodative central banks and even higher policy rates to come. Whilst is it very difficult to be shielded from these losses in absolute terms in a long-only bond fund, an active approach to fund positioning means that some of these losses can be mitigated. By leveraging on many years’ experience and resolutely sticking to this active approach to managing government bond funds, we have been able to take advantage of the numerous opportunities that have presented themselves in this volatile and challenging environment across the range.
For Professional Clients only, not suitable for Retail Clients. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount 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.