In their latest meeting, the Bank of England (BoE) held Bank Rate at 5.25% with the vote split 1-6-2 for a cut-hold-hike respectively. While market expectations were for a hold, it doesn't change our view that the BoE will start to ease monetary policy later this year.
We are buying duration to lock in these higher yields while we still have the chance, as we believe these yields may not be around in a few years' time. The good news for bond investors is that the next rate moves from the BoE are likely to be cuts, rather than hikes, and while the timing of this continues to be data dependent, this has historically been a positive tailwind to performance for high quality fixed income markets, particularly short dated bonds.
Restrictive policy is starting to bite, inflation is falling
The current stance is clearly seen as restrictive from the BoE, given they forecast 1.4% CPI in two years based on constant rates (see figure 1). Inflation is coming down, with UK inflation falling from over 11% in 2022 to 4% in December 2023. However, December's inflation print was a timely reminder than the inflation trajectory, while clearly downward, won't be a smooth ride.
Accordingly, we would caution that rates may still need to remain higher for longer in order to tame the last mile of sticky inflation, but they don't need to remain at these elevated levels. In addition, this is all based on the assumption that we do not enter a recession, should we experience a balance sheet recession (not our base case by the way), it is likely the demand destruction would be enough to bring inflation down and warrant a more accommodative stance.
Figure 1: UK CPI versus BoE forecasts
Source: Fidelity International, Bank of England, 1st February 2024.
Banking sector jitters warrant caution, restrictive rates are still feeding through the economy
The recent jitters in the banking sector, particularly around New York Community Bank and its commercial real estate exposure, are a timely reminder that the full impact of tighter monetary policy is still feeding its way through the economy.
Monetary policy famously works with long and variable lags. In each of the Fed hiking cycles since the 1950s, only once did a recession occur within 18-months of the first Fed hike. In this hiking cycle, the Fed first hiked in March 2022, so based on history at least, it would have been unlikely that we hit a recession through to September 2023. We are now in the more usual timeframe for a recession following a hiking cycle.
Furthermore, as we discuss here there are good reasons to think that the transmission mechanism has slowed somewhat, given the structure of the mortgage market and corporate borrowing. Households, and corporates, did a good job of terming out debt and moving onto fixed rate financing structures during the era of ultra-easy monetary policy. Importantly, this does not mean the transmission is broken, it's just delayed.
Short dated corporate bonds look particularly attractive ahead of a cutting cycle
With rate cuts on the horizon, we continue to like high quality corporate bonds, particularly given the additional yield advantage (via the credit spread) over government bonds. Within the investment grade credit landscape, we like the short dated (sub-5yr) part of the curve, in particular. Short-dated bonds are an attractive risk-adjusted proposition ahead of a rate cutting cycle for two reasons.
Firstly, the short end of the curve is influenced more by monetary policy than the longer end of the curve which, in a cutting cycle, means there can be a larger positive interest rate impact. Furthermore, an inverted yield curve allows active bond investors to take advantage of higher yields for less risk and short dated credit markets have historically performed well following the inversion of the curve, as we highlight here.
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates rise and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Due to the greater possibility of default, an investment in a corporate bond is generally less secure than an investment in government bonds. Fidelity's range of fixed income funds can use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Reference to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes. Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document (Key Information Document for Investment Trusts), current annual and semi-annual reports free of charge on request by calling 0800 368 1732. Issued by FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0224/386097/SSO/NA