UK moves closer to Europe… on rate cuts!
Jenna Barnard, Co-Head of Global Bonds, considers the dovish comments from the Bank of England, which suggest it could soon be following Sweden’s Riksbank and the Swiss National Bank in cutting rates.
3 minute watch
Key takeaways:
- The Swiss National Bank and Sweden’s Riksbank have fired the starting gun on rate cuts from developed market central banks; comments from the European Central Bank and the Bank of England signal a high likelihood they will follow with cuts in the coming months.
- Rates divergence with the US Federal Reserve (Fed) is unusual: it is necessary to go back to the 1970s/80s to see the Bank of England or the Bundesbank cut before the Fed, but the sticky inflation narrative is looking increasingly isolated to the US, allowing policy elsewhere to diverge.
- Markets are only pricing in modest rate cuts, but any sign of labour market weakness and bond markets could respond substantially with declines in yields and rises in bond prices.
Inflation: The rate at which prices of goods and services are rising in the economy. Core inflation typically excludes volatile items such as food and energy prices. A common measure for inflation is the Consumer Price Index (CPI).
Recession: A significant decline in economic activity (negative economic growth) lasting longer than a few months. A soft landing is a slowdown in economic growth that avoids a recession.
Sticky inflation: Inflation that stays at a level that is stubbornly above a central bank’s target rate.
Yield: The level of income on a security over a set period, typically expressed as a percentage rate. For a bond, at its most simple, this is calculated as the coupon payment divided by the current bond price.
IMPORTANT INFORMATION
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
There is no guarantee that past trends will continue, or forecasts will be realised.
Jenna Barnard: Today is Thursday, May the 9th and we just had the Bank of England quarterly inflation report.
It caps off quite a dovish week for central banks. We started the week with an interest rate cut from the Swedish Central Bank. That was the latest one in the developed world. In March of this year, we had a cut from Switzerland and today we have got a Bank of England that is signalling rate cuts are possible either at their June meeting or their August meeting this summer.
There is obviously a degree of extra evidence required on inflation persistence and inflation staying low and close to target. But this was a pretty dovish meeting from the Bank of England. And really, it signals that we’re moving on from this period of higher for longer, the mantra from central banks, that interest rates were going to be on hold for a persistent period.
If you remember that the last rate hikes were broadly last July, August, September, depending on the central bank, we will have been on hold for between nine months and a year in this interest rate cycle. That’s not atypical. It’s the kind of long holds that we have seen periodically in the recent past, but it is unusual for other central banks to be cutting before the Federal Reserve. You would have to go back to the 1970s and early 1980s to see the Bundesbank and the UK cutting before the Federal Reserve. So that, I think, has manifested as a degree of interest rate divergence, so outperformance of bond markets in the likes of the UK, Germany, Canada’s been a big outperformer, even Australia this year. And that’s, I think, a natural and understandable reaction to the situation we are in.
But for bond markets as a whole, I would not taint every country and every central bank with this sticky inflation narrative that we have heard emanating from the US recently. In many countries in the developed world, inflation has actually surprised the downside this year, albeit broadly in line with expectations. So in that sense, we are in the bond market moving on to a new era, away from the aggressive hikes and then the higher for longer.
There is not a huge amount of conviction from the central banks in terms of the scale and quickness of the rate cuts and that is because labour markets have not broken anywhere yet.
But the bond market as we sit here today is priced for pretty modest rate cuts for the likes of the UK, the US. It has interest rates coming down from around five and a quarter percent to four percent in total over the next few years. For the ECB (European Central Bank) it would be about four percent today to around two and a half percent. These are pretty soft landing type rate cuts which are priced, reflecting the progress we have made on disinflation.
If you saw any signs of labour market weakness, then the bond market would have to price a higher probability of very aggressive rate cuts. And we are only seeing modest signs of that in the likes of Canada. The UK there seems to be some weakness, but nothing dramatic. And so I think bond investors will really remain on high alert for any signs of labour market weakness.
These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.
Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
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Important information
Please read the following important information regarding funds related to this article.
- An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
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- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- CoCos can fall sharply in value if the financial strength of an issuer weakens and a predetermined trigger event causes the bonds to be converted into shares/units of the issuer or to be partly or wholly written off.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
Specific risks
- An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall. High yielding (non-investment grade) bonds are more speculative and more sensitive to adverse changes in market conditions.
- When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise (or are expected to rise). This risk is typically greater the longer the maturity of a bond investment.
- Some bonds (callable bonds) allow their issuers the right to repay capital early or to extend the maturity. Issuers may exercise these rights when favourable to them and as a result the value of the Fund may be impacted.
- Emerging markets expose the Fund to higher volatility and greater risk of loss than developed markets; they are susceptible to adverse political and economic events, and may be less well regulated with less robust custody and settlement procedures.
- The Fund may invest in onshore bonds via Bond Connect. This may introduce additional risks including operational, regulatory, liquidity and settlement risks.
- The Fund may use derivatives to help achieve its investment objective. This can result in leverage (higher levels of debt), which can magnify an investment outcome. Gains or losses to the Fund may therefore be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- If the Fund holds assets in currencies other than the base currency of the Fund, or you invest in a share/unit class of a different currency to the Fund (unless hedged, i.e. mitigated by taking an offsetting position in a related security), the value of your investment may be impacted by changes in exchange rates.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- CoCos can fall sharply in value if the financial strength of an issuer weakens and a predetermined trigger event causes the bonds to be converted into shares/units of the issuer or to be partly or wholly written off.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
Specific risks
3 minute watch
Key takeaways:
- The Swiss National Bank and Sweden’s Riksbank have fired the starting gun on rate cuts from developed market central banks; comments from the European Central Bank and the Bank of England signal a high likelihood they will follow with cuts in the coming months.
- Rates divergence with the US Federal Reserve (Fed) is unusual: it is necessary to go back to the 1970s/80s to see the Bank of England or the Bundesbank cut before the Fed, but the sticky inflation narrative is looking increasingly isolated to the US, allowing policy elsewhere to diverge.
- Markets are only pricing in modest rate cuts, but any sign of labour market weakness and bond markets could respond substantially with declines in yields and rises in bond prices.