Bond investors are betting on a rate rise

The fall in the value of sterling post-Brexit, the likely rise in the cost of imported goods to the UK and the stimulus policies of newly elected US President Trump has created the expectation of rising inflation. The BoE is predicting UK inflation to hit 2.7% in 2017.

This revival in inflation expectations has seen US 10 year Treasury bond yields rise to 2.34% from 1.8% on Donald Trump’s election. This rise is down to inflation expectations and the likely rise in US interest rates.

Yields on US 10 year Treasuries are the benchmark price for global money. Any rise will have the impact of forcing up yields in both sovereign and corporate debt in the rest of the world. Bond yields have risen in the Eurozone’s economically stressed countries. Italian 10 year debt exceeded 2%, while Portugal’s hit 3.5%. Even ultra-safe German 10 year Bunds saw yields rise to 0.32% having recently been in negative yield territory.

When yields are increased to counter inflation invariably bond prices will fall to compensate. In the second week of November the resulting price fall saw a massive US$1tn being wiped off global bond prices as yields around the world followed suite.

We are facing a world economy where QE is having less impact and governments are now seeking to use fiscal stimulus rather than monetary levers. We can see a general move to tax cuts, infrastructure spending and house building that is putting people and materials to work. The policy shift can create growth but also inflation. It is the inflation threat in the US that is spooking the bond markets as inflation in other developed economies is not so apparent.

Recently UK 10 year gilt rates jumped to 1.1% following news that the consumer price index (CPI) had reached 1%. The UK is expected to see CPI rise to 2.7% in 2017. Bond yields are particularly vulnerable to inflation. This is not just a UK story as yields all around the world are up.

Overall, short duration bonds offer some protection from jumps in US interest rates. US investment grade bonds look relatively attractive as does UK and European investment grade credit due to the BoE and ECB corporate bond buying programmes.

There has been a particular upside in local currency emerging market debt due to currency stability and improving economic fundamentals such as current account balances. Local currency bonds generally have lower duration than hard currency EM debt which should make them more resilient to a spike in global long term bond yields.

It is against this background we have set out our portfolio recommendations.

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