Yields dropped throughout the curve and UK government debt prices climbed. This action was modest and predictable because, months after inflation returned to goal in May, a rate drop was predicted. Harder to predict is what occurs next; this complicated the plans of global bond managers who have to consider happenings in the US, which has not yet lowered rates, and the eurozone, where officials moved in June. Based on overnight index swaps, financial markets predict a November rate decrease for the UK after the first fiscal event of the new government—the Autumn Budget on October 30.
Although central banks have improved in recent years in their ability to convey their intentions, legislators remain hesitant to indicate their future policies in advance. “I’m not offering you any view on the road of rates to come,” BoE governor Andrew Bailey stated on August 1. Bond managers must not only interpret central bank message but also compare these with daily changing financial market expectations in order to determine the next action on rates. Every now and again they contradict one another.
How Do Bonds React to Falling Rates?
Financial markets predict that interest rates in the US, Europe, and the UK will drop much further this year and in 2025; the exact timing and degree of the reduction are still unknown. Although more consistent inflation has delayed this softening of monetary policy in 2024, it is still seen as a natural process.
Like elsewhere, UK government bond rates have responded ahead of anticipated changes in monetary policy. For instance, the 2-year gilt now yields roughly 3.60%, while the short-term UK government paper had a return of 5% a year ago.
While the yield of last year is more appealing naturally, the price of the bond changes inversely. Bond investors get total returns from yield and capital appreciation; so, a succession of rate reductions would raise bond prices and lower yields. While some investors demand income, others want growth and are thus willing to give up some yield. Another factor of importance here is real yield; a bond earning 5% was aesthetically pleasing but did not outperform inflation at 10%. With UK inflation already around 2%, the benchmark 10-year gilt provides over 4%.
Whether investors hold the instrument to maturity as well as the amount they paid and rates/inflation predictions at the time determine much of it. The coupon is what stays “fixed” during the bond’s lifetime.
What Do Bond Managers Think?
Cash and money market funds have begun to provide appealing returns of around 4% or 5% when rates were turned up. Because they provided comparable income but without the complexity of holding fixed income, they were considered as reasonable substitutes for bonds. Though they cannot provide financial profits, cash deposits are the most “safe” investment available and provide more capital protection than bonds. “This made perfect sense in the low/rising bond yield and high deposit rate timeframe. Now, as we go into the next phase of the interest rate cycle, this is no longer the case, claims Colin Finlayson, manager of the Strategic Bond Fund and Gold-rated Aegon Absolute Return Bond Fund. He contends that investors might now move out of cash and cash-like securities back into bonds as the market is at an inflection point. “Central banks are now set to cut interest rates and deposit rates, in turn are set to decline,” he states in his remarks. “At the same time, bond yields are once more appealing and present chances for both income and capital appreciation.” Bond investors can have conflicting emotions while mortgage holders may urge the Bank to rapidly lower rates in order to make their loan less expensive. Neil Mehta, a portfolio manager on the BlueBay Investment Grade Euro Aggregate Bond fund with a Morningstar Medalist Rating of Silver, contends that August’s rate decrease may have been a mistake in spite of mounting pressure on the Bank of England to lower. He writes in an email, “there was no strong imperative or necessity” to lower prices today. “The five MPC members that voted for a cut may have acted too quickly, cutting for the sake of cutting, without the data to support the decision.”
Will There Be More UK Rate Cuts?
Mehta contends that the most recent policy action could be “one and done” and that the Bank’s capacity for future cuts this year is less than that of markets now demand. The European Central Bank could have established a precedent here: while it indicated ahead of time that it would reduce in June, it has since been more cautious regarding the date of the next reduction.Though recent inflation figures have been higher than projected, September is seen as the most probable timeframe.Towards the end of the year, UK inflation is also predicted to climb once again.
Rates “higher for longer” would sustain yields at present levels for UK debt. In a report released after the ruling, Alliance Bernstein’s European economist Sandra Rhouma suggested that short term rate or yield adjustments would not be significant.
“Guidance suggests that rates will need to be limited for “sufficiently long” to guarantee inflation gets to goal stably throughout the medium run.
“This suggests that there is no quick route to neutral [interest rates] for the BoE right now. Thus, in policy normalisation, we should anticipate a relatively slow road waiting for the facts.
BoE Should Cut Faster
Another Silver-rated fund, Jupiter Strategic Bond, has fixed income manager Harry Richards offering a different perspective. Since the Bank has had to respond to a swift tightening in monetary policy since 2021, since when rates have gone from 0.1% to 5.25%, he exhorts the Bank to move on with faster rate cuts to save the economy. Higher rates cause individuals and businesses to find borrowing more costly. Critics of the Bank contend that this has slowed down an economy just avoiding a recession.
To prevent causing permanent damage to the labor market in particular and the economy overall, the BoE should relax policy “much more aggressively” into 2025.
Conversely, he believes the incoming Labour administration draws foreign investors into UK fixed income by bringing fresh political stability to the country.
For gilts, what may this mean? Driven by the better political environment, flows into UK bonds from the scenario Aegon’s Finlayson of rotation out of cash and money markets presents might raise prices and lower rates. The same will be true with rate reductions. Prices are pushed up by more fixed-income instrument purchasers; this process is discussed in a recent piece, “Want to Buy Government Bonds? Exercise caution.” In the financial crisis of the eurozone more than ten years ago, investors sold out of debt issued by debt-ridden nations like Greece, which fell prices but boosted rates in opposite direction.
What the Fed Does Next
Although the situation is more complex, bond investors in the UK might have regarded August 1’s Bank decision as launching the starting pistol on a series of rate cuts. For global bond managers, much relies on future Federal Reserve actions. US and UK interest rates are now comparable—5% and above—and their bonds yield likewise. The primary interest rate of 3.75% is also lower than the debt rates in the Eurozone.
The Fed may still cut further over the next year or two even after the BoE. Cutting after the BoE Whereas UK rates are predicted to be about 4% then, Morningstar’s senior economist Preston Caldwell forecasts US rates to be around 2% by the end of 2026. That would change the case for US debt ownership against UK and European debt. Aegon’s Finlayson notes this increases the significance of controlling “duration risk,” the vulnerability of bonds to interest rate fluctuations. Bonds are more vulnerable to this risk the longer term the obligation is.Once again, this is a complicated matter involving many moving elements including politics, credit ratings, economic development and inflation. The fixed income area is no exception; financial market stories vary constantly: “lower for longer,” “higher for longer,” “transitory” vs “sticky” inflation.
