There is currently much head-scratching in financial markets with regard to one of the most stable relationships in financial history: the falling of bond prices when consumer prices rise. The link seems to be broken at the moment.
Inflation has risen to record-high levels in recent months, and the 10-year UK bond yield has fallen to a fresh five-month low. What is the reason for the rally in UK Treasuries? Obviously, investors believe that peak growth and peak expectations are already behind us. The US Federal Reserve’s (Fed) shift towards earlier-than-expected rate hikes has removed fears that inflation may run out of control, and falling purchasing managers’ indices from record-high levels support the case for decelerating economic growth. This is a normal mid-cyclical consolidation is driven by base effects and most likely set to continue at least until Q1 2022.
Much depends on the longer-term inflation outlook. Our economists and most other market pundits argue that the surge in inflation is temporary, but how long exactly is ‘temporary’? The answer will notably depend on the strength of second-round inflation effects. Wage growth and worker shortages will be crucial indicators to watch out for. Further coronavirus-induced supply-chain disruption in emerging markets is another factor to consider. Then there are rent prices, which make up ca 20% of the core inflation index targeted by the Fed. In April, UK house prices rose 14.6% against the same period last year, while rents are still below pre-pandemic levels. There may be some upside as well.