BoE hike: 'One of the most attractive set-ups' for bonds in decade

The portfolio manager at Quilter Investors said the recent rate hikes, coupled with the country's economic and inflation outlooks, meant there was increasing opportunity in fixed income for diversification and income generation.

Today (Thursday September 22) the BoE raised rates by 0.5 percentage points for the second month in a row, but this was below market expectations of a 0.75 percentage points rise, especially after seeing such a hike in the US the day before.

Patel said the economic environment was shaping up to one in which inflation could slow in the near term and economic output could rapidly deteriorate.

However, he said he expected the new government's fiscal policies - possible tax cuts and an energy price guarantee - to add to inflationary pressure in the medium term.

We still think the Bank has a lot of hiking left to do.Luke Bartholomew, Abrdn

Meanwhile, the Bank is continuing with its quantitative tightening programme, which sees gilts previously purchased by the central bank sold to the open market. This typically raises yields and lowers bond prices.

Patel said: "The Bank of England is hiking rates into an already slowing growth and forward inflation profile.

"A terminal rate (the point at which central bank officials think they can stop hiking interest rates) of above 4 per cent has already been priced into markets.

"The supply/demand dynamics are a risk in the short-term, but we are seeing increasing opportunity in fixed income from an income yield, traditional diversification perspective.

"Should rate cuts come down the road, then the scope for capital gains is also improving.

"For investors, this has now produced one of the most prospectively attractive set-ups for fixed income assets in at least a decade."

Others were not so sure. Ed Hutchings, head of rates at Aviva Investors, said he expected gilt yields and sterling to remain "somewhat unloved" for now.

"With financial markets at the margin expecting a hike of 0.75 per cent, the decision to do 0.50 per cent but to begin quantitative tightening in October feels somewhat more of a balanced outcome for financial markets.

"However, given the backdrop of fiscal tailwinds, strong employment data and inflation yet to fall, I would expect both gilt yields and sterling to remain somewhat unloved for the foreseeable," he said.

The Fed's hike of 0.75 percentage points to a funds target rate of between 3 and 3.25 per cent yesterday had pushed sterling to its weakest level against the dollar since 1985. It has since regained slightly, hovering at just above $1.13 this afternoon.

The UK two-year Treasury surged to 3.55 per cent in the hours after today's announcement, while the 10-year gilt had risen to 3.46 per cent by mid afternoon, flattening the yield curve.

"With the Bank itself saying in its notes that there was a 'material risk' of persistent domestic price and wage inflation, even though the energy price cap will bring down headline inflation, bond investors concluded that there could be plenty more rate hikes to come," said Sam Benstead, deputy collectives editor at Interactive Investor.

"In response, they sold bonds, with the yield of the 10-year UK gilt jumping from 3.3 per cent to about 3.5 per cent following the announcement."

The flattened curve showed the Bank had a "credibility problem", said James Athey, investment director at Abrdn.

He said: "The decision today was unequivocally dovish and yet short-dated yields are higher and the curve is flatter. The market is basically telling the Bank that its current stance is wrong and in the coming months it will be forced into a more hawkish stance."

He added interpreting what this meant for the wider bond market was difficult. "High inflation, a not-so-hawkish central bank, plummeting sterling, a potentially huge fiscal boost and the imminent selling of gilts by the Bank should all mean higher yields and a steeper curve," he said.

"However the market continues to price the tightening they expect, not what the BoE is forecasting, and this is naturally weighing on future growth expectations, which is pushing long end yields lower.

"If the BoE would just grasp the nettle there would be real value in the gilt market. Until they do its very difficult to want to step in."

His colleague Luke Bartholomew, senior economist at Abrdn, said the fact the hike was smaller than expected might give some relief to fixed income investors.

However, he added: "We still think the Bank has a lot of hiking left to do. And the decision to start selling the Bank’s gilt holdings at the same time that the government is likely to announce a large new issuance of gilts to finance its fiscal easing will probably keep gilts under selling pressure."

All eyes are now on Liz Truss's government's mini budget tomorrow (September 23), when it is expected to announce further tax cuts on top of its £150bn energy price guarantee.

A reversal of Boris Johnsons's government's 1.25 percentage point National Insurance hike has already been announced.

Jeremy Batstone-Carr, European strategist at Raymond James, said if the government’s plans work, sterling might stage a revival on the foreign exchanges, encouraging interest from overseas.

However, if the chancellor’s increase in extra borrowing fails to generate growth, the entire gilt-edged curve could rise yet further as confidence in the economic recovery plan diminishes.

"This potential outcome, combined with the possibility that the Bank’s quantitative tightening programme also adds to the flow of gilt-edged back onto the market, should serve as a warning to those looking for opportunities to proceed with caution," he warned.

Alastair George, chief investment strategist at Edison Group, said: "Despite the government energy price guarantee mechanically lowering inflation in the short-term, the Bank of England is also warning this guarantee represents a fiscal stimulus which will need to be embedded into new inflation forecasts in November.

"In combination with the tightness of the labour market it expects this to add to domestic inflationary pressure in the medium-term – with the clear implication this period of tighter monetary policy may be further extended."

carmen.reichman@ft.com