UK cuts, US closer - what now for bonds?

US interest rates: eyes on September 

Markets have come to expect very little from US Federal Reserve (Fed) meetings of late. Much of the recent volatility in US bond markets has been driven by the economic data and not so much by surprises in monetary policy or Fed communication. And in that respect Wednesday (31 July) was no different. US interest rates were left unchanged, much as the market had forecast. The FOMC statement and Chair Powell’s press conference both suggested that the FOMC is moving closer to a rate cut and should the inflation data come in as expected, September is very much live for the first rate cut.

On the labour market, jobs gains have ‘moderated’ from ‘remained strong’, and the inflation is considered as being ‘somewhat’ elevated, rather than elevated. Confidence is building that inflation is moving sustainably towards the 2.0% target. Furthermore, there appears to be a shift away from just focusing on inflation to a more balanced consideration of the dual mandate. But they have by no means backed themselves into a corner on a September rate cut, should the data surprise on the strong side.

US bond markets are well priced for interest rate cuts; expectations are that US interest rates will be cut to 3.25% by the end of 2025. Five-year US bond yields, which peaked at 4.7% in April this year are now around 3.8%. They have performed well and will need the US to deliver on rate cuts as we move into the later part of 2024. We have been overweight US bond markets over the last few months, particularly at the shorter end of the curve. Despite their strong recent performance, we are happy to remain positive on dollar markets but looking more at steeper curves rather than outright longs.

UK interest rates: Markets too optimistic?

At Thursday’s Bank of England (BoE) meeting the committee voted by a majority of 5-4 to cut the UK base rate from 5.25% to 5.0%. This move was somewhat expected by the market, with the probability of an August cut being around 55% priced ahead of the meeting. For those not expecting a rate cut in August, September was seen as the next most likely option, with one cut of 0.25% fully priced across both meetings. The slim committee majority in favour of a rate cut reflected how finely balanced the decision was and the closeness of the call was replicated further in the minutes of the meeting.

Inflation has fallen back towards the Bank’s 2.0% CPI target and prospects of hitting the target sustainably have improved. That has provided some reassurance to the BoE that they can begin easing monetary policy from the current very restrictive levels. However, some members on the committee remain nervous about the persistence of elevated inflation, particularly in the services sector, and whether structural shifts in the economy pose a threat to the sustainability of inflation around the 2.0% target over the medium term.

Furthermore, whilst the labour market has loosened, the committee noted it remains tight by historical standards. Like other central banks, the BoE is still data dependent – in the BoE’s case, monitoring those risks to inflation persistence.

The government has announced that the Budget will be held on 30th October, and, unless economic conditions shift materially in the short term, it seems likely that the BoE will wait until after the Budget before cutting rates again. November 2024 looks likely for a second rate cut of 0.25%, despite the BoE’s expectations that spot inflation will be rising towards 2.7% as we move through to the later part of the year.

Yesterday’s 5-4 vote split is one of the slimmest majorities to kick start a rate cutting cycle in the BoE’s history. Thursday’s meeting was about as hawkish a rate cut as the MPC could have delivered. With a newly elected government in place, the BoE upgrading its forecasts for economic growth and concerns within the MPC about a structural shift in the economy that puts upward pressure on inflation, markets should not expect a rapid rate cutting cycle.

By the close of play on Thursday the market was forecasting two additional cuts in 2024, with an additional four cuts priced for 2025. UK government bond yields continued their recent downward move after the meeting, led by the front end of the curve; five-year maturity gilts closed the day around 3.65%. We have been positive on UK government bonds, particularly five-year maturity gilts, since the summer of last year. Back then rates were being priced to 6.0%- and five-year maturity gilts were just shy of 5.0%. With five-year gilts now around 3.65%, and rate cuts well priced to a terminal level of 3.25%, we think gilts are looking less attractive, we are more cautious on duration and exposure to bonds in this part of the curve.

This is a financial promotion and is not investment advice. 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.