After spending much of the post-Great Financial Crisis era in a reasonably controlled range, inflation has roared back to life in the last couple of years, providing dramatic consequences for the bond market in 2022, along with other political events. This will be little news to anyone keeping even a casual eye on markets.
Looking ahead, how inflation develops is of interest because it can have consequences for the seemingly attractive yields in government bonds markets. With inflation in the UK and US looking to be operating with 2% floor, rather than ceiling, we feel there are some risks to bond markets.
Making waves
There have been several waves of inflation in recent years, as food and goods prices were heavily influenced by lockdowns during the Covid-19 pandemic. Then came the reopening, prompting renewed demand for services which were scrambling to rehire staff, provoking higher wages. This was supplemented by various supply chain bottlenecks, issues such as the blockage of the Suez Canal and then the war in Ukraine impacting everything from oil prices to bread.
Source: ONS, February 2025
Throughout 2024, inflation in the UK felt the benefits of energy and fuel prices becoming less volatile. However, the services side of the equation is proving sticky and wage inflation has been picking up, now at 5.9% when including bonuses. This is helpful for the UK economy, given wages are rising in real terms but it doesn’t take fuel away from the fire. It is also worth noting that goods prices have been helped by a deflationary wind blowing from China, where factory gate prices as measured by the Producer Price Index (PPI) have been declining for some time, as shown below. In our view this looks to be an inflation situation that is vulnerable to the upside.
Source: National Bureau of Statistics of China
2025
As with a lot of international data, comparison can be difficult and there are discrepancies between the variety of measures available. We will choose to look at it on a harmonised basis here as developed by the European Central Bank. The main difference with the US CPI figure is that the harmonised methodology tries to include the rural population and excludes housing costs. They are interesting topics in themselves, but we will leave that for another day.
Turning to this year. We have already experienced an uptick in the UK headline CPI to 3.0%, which compares against a Bank of England forecast of 3.7% in the third quarter of the year. This already seems to be tracking ahead of expectations. In the US, a similar picture is emerging. Headline CPI has been a little hot, although some measures that the Fed prefers to watch, such as PCE, are looking slightly better behaved.
Source: ONS & Eurostat as of 03/03/25
Bond consequences
Throughout winter, bond markets have been slowly digesting the potential of higher inflation, however economic weakness has been increasingly influencing yields of late.
The UK yield curve has steepened and some compensation for tolerating longer duration is being offered, although in our view not enough. If we simply look at a benchmark level, our short-duration gilt allocation has a duration of just under three years, whilst the broader gilt market has duration of just under nine years. Currently short-dated gilts are only yielding around 0.5% less than the broader gilt market. An additional level of yield we will happily give up, to protect against the inflation risks we see on the horizon.
Source: AJ Bell SAA benchmarks
