If 2024 is to be the ‘year of the bond’, inflation has to fall. The assumptions around inflation have had a wobble since the start of the year, as the US CPI reading for December came in ahead of expectations, and economic growth continues to soar. This has destabilised bond markets and seen yields drop again. How confident can investors be about the trajectory of inflation – and therefore bond markets?
Inflation didn’t miss by much in the US – 3.2% versus 3.1% predicted. In the Eurozone, inflation climbed to 2.9% in December, from 2.4% in November, but was back down to 2.8% in January. In the UK, inflation rose marginally to 4% in December, up from 3.9% in November, after economists had predicted a slight fall.
Nevertheless, it has been enough to trouble the bond markets. The US 10-year treasury yield is back above 4%, and shorter-dated yields have moved even higher. The UK 10-year gilt yield has moved from around 3.5% at the start of the year to just under 4% today and the 2-year from 4% to 4.5%. This disrupts the view that government bonds are a one-way bet for the year ahead.
The US Federal Reserve has pushed back on market expectations for a rate cut in March, saying that “the committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably towards 2%”.
Nevertheless, most believe that rate cuts are deferred rather than cancelled. Anthony Willis, investment manager on Columbia Threadneedle’s multi-manager team, says: “Chair Jay Powell spoke positively about the progress made so far but said there was a need to have more confidence on the disinflation path”. The Fed is “not looking for better data, but a continuation of the better data” that has already been seen. Powell said that a March cut is not the most likely case, because the committee is unlikely to have hit that level of confidence by then.
“Futures markets are pricing only a 35% probability of a cut in March – though the Fed will have two more inflation data points to digest by then. Powell’s comments suggest that if inflation remains on track, then even if March is not likely, rate cuts are coming soon,” adds Willis.
Jim Leaviss, manager of the M&G Global Macro Bond fund, also believes rate cuts are still likely: “Inflation has started collapsing – both core inflation and headline inflation. The numbers that the Fed looks at – core PCE inflation – are back down towards 2%. It is going in the right direction.”
That said, Leaviss also believes there may be longer term risks to the current benign inflation picture, particularly in the US. He points out that there is usually a balancing mechanism for government debt. Governments borrow more when the economy is weak; and when the economy is weak, inflation is falling and interest rates are generally coming down as well.
However, he adds, “this relies on a world in which governments borrow more when economies are weak, not where they borrow more to juice an already strong economy.” The US has seen two quarters of 4-5% growth, and its employment market is very strong. Nevertheless, he believes that widespread disgruntlement with rising prices is likely to usher Donald Trump into the White House, and that tax cuts are likely to be his priority once he gets there.
Tax cuts have historically been a significant contributor to rising debt to GDP. Leaviss says Trump’s election is likely to be inflationary and the US government will have to borrow more at higher bond yields.
Charlotte Yonge, assistant manager on the Personal Assets Trust, is also alert to the risks inherent in US borrowing: “The US government is spending money like it’s going out of fashion. This has provided a great fillip to growth. The fiscal deficit – the amount by which government expenditure exceeds receipts – was $1.3trn for the first three quarters of 2023, or nearly 5% of GDP. We have never seen this level of government spending outside of a recession or its immediate aftermath. On a gross basis, the fiscal outlay relative to the size of the economy is approaching a level consistent with the peak in government support provided during the Second World War.”
She believes this phenomenon is consistent with a multi-decade long trend and is not unique to America. It is both a symptom and a cause of lower pain thresholds on the part of electorates around the world. She adds: “We expect that the next recession will see a fiscal response on top of a monetary one, such that the benefits extend beyond owners of capital to labour as well. This, as we saw with Covid, is likely to mean inflation for goods and services on top of asset price inflation. Governments’ increased readiness to respond to economic hardship will help define the shape of the next recession and subsequent rates of inflation.”
The consequence of this shift is likely to be more volatile and structurally higher inflation than we have experienced over the course of the last 10-15 years. In response, the trust now has around 40% in index-linked bonds, mostly in the US. This is well above the trust’s long-term average of around 30%.
For Leaviss, the bond market is still good value, and they are keeping a watching brief on the election outcome. He adds: “The Fed says that long-term interest rates, based on demographics, technology, globalisation, and those long-term factors that determine how much we save and invest, will be around 2.5%. The treasury market thinks it’s more like 5%. We’ve never seen this degree of dislocation.” As a result, he is focusing on longer duration government bonds, believing this is where the opportunity lies.
Bonds markets have re-set since the start of the year and now reflect less optimism on rate cuts and falling inflation. Inflation is unlikely to bounce back significantly, but there are always unpredictable elements, such as the oil price, and markets are jumpy. It can still be the year of the bond, but investors will need to be selective.