JP’s Journal: Bonds on the rise

Last week saw a marked rally in government bonds – with the major exception of France.

However, even with headlines warning of a French debt crisis and concern about political paralysis, the impact on French government bond yields was muted; the 10-year rate closed at 3.1%, only 3bps up on the week. Looked at in spread terms the situation is less benign, as the premium over 10-year German yields widened to 0.8%, breaking out of the 0.4-0.6% range seen in the last two years.

There were several factors helping bond markets last week. The main driver was US inflation data. Core Consumer Price Index (CPI) inflation rose by 0.2% in May whilst the core measure of Personal Consumer Expenditure (PCE), the Federal Reserve’s (Fed) main inflation measure, increased by a bit less. The headline annual CPI rate of 3.3% was helped by lower gas prices and food inflation was minimal. Housing costs still rose and used vehicle prices bounced higher. Overall, a pretty good outcome – and one liked by bonds.

The US Fed updated its ‘dot plots’ last week. In the March forecasts the median participant projection was for three rate cuts this year; it is now one. This hawkish trend, however, was offset by other factors. The accompanying statement on inflation referred to further progress towards the 2% goal and the ‘plotting’ for 2025 showed an extra cut – now four in total. The main message remained around data and wanting more confidence in a downward trajectory for inflation before cutting rates. Reference to potential unexpected weakness in the labour market as a trigger for rate cuts further supported government bonds. Against this background 10-year US treasury yields fell from 4.4% to 4.2% and the 20-year real yield declined to 2.15%, after closing in on 2.5% around mid-April.

In the UK, 10-year gilt yields finished below 4.1%, a fall on 20bps on the week. From a bond perspective, the economic news last week was mixed. Pay growth remained strong, with the April data impacted by the 10% increase in the minimum wage. Headline regular pay growth at 6.0% remains too high for comfort. However, there are signs of the labour market cooling. The unemployment rate rose to 4.4% from 4.3%, with employment down 139,000. In addition, vacancies decreased over the March to May quarter.

The message for the GDP data confirmed the subdued nature of UK economic activity. Manufacturing output fell as did construction (where is summer?) but services rose, helped by strong contributions from the information and communication sectors. There was a drag from the wholesale/retail category but consumers don’t like shopping in the rain and that may therefore be temporary. PMI business surveys indicate a slightly better outlook and it seems possible that Q2 could see growth of around 0.4%. An August cut is still a coin toss.

Credit spreads were under pressure in both investment grade and high yield. Non-gilt sterling indices saw spreads widen back above 1%, a 7bps increase. There was noticeable weakness in French banks, particularly subordinated debt, but there was more generalised softness than seen in recent months. High yield followed a similar pattern to other risk assets, with spreads 10-20bps wider.

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