How to invest in bonds as inflation peaks

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How to invest in bonds as inflation peaks
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The chances of economies achieving a “soft landing” as interest rates rise are “almost zero”, but bond investors can profit either way, according to a several fixed income investors. 

Central Bankers are presently trying to raise interest rates sufficiently to force inflation down. But in doing so they want to avoid a sharp recession, and ideally achieve a so-called soft landing.

Phil Milburn, bond manager at Liontrust believes the fact that core services sector inflation remains high, and global economic growth is weakening despite the full impact of tighter monetary policy not likely to be felt for several months due to the traditional lag between rising rates and real economy impact, means that a recession will occur later this year.

He said: “Bond market volatility is very high now, we are in a tug of war as policy makers battle to control inflation, but also have to ensure financial stability with the banking system.

"I don’t think we are headed for another banking crisis, but what is interesting is that the market has started to revise down its expectations of future rate rises in the US, the expectation had been that rates would rise by another 0.75 per cent, but this has been revised down to another 0.25 per cent.

"This is because the stresses in the banking system will cause banks to tighten their credit conditions anyway, which has much the same impact as higher rates, and is negative for growth."

If bank lending conditions are tightened at a faster pace than central bank interest rate rises, the money supply could contract at a greater rate than if rates rose, the velocity of the money supply, that is. As a result the pace at which the money that is created is moving through the economy is also slowed.

Both of those considerations are extremely negative for economic growth.

A situation whereby economic growth prospects are declining and market expectations are for rate rises to slow would intuitively be a positive for long duration bonds, but Milburn said markets were already pricing in this outcome.

With that in mind he has been reducing his duration a little by taking some profits, though he remains long duration overall. 

'Not cautious to the maximum degree'

Paul Skinner, investment director at Wellington Management, said: “Markets had started to price in the soft landing. But what has happened is really just a classic interest rate tightening cycle as we have seen before.

"And we have seen that in the past bringing about a soft landing is not really something central banks have actually been able to do.”

He described the weakness in bond markets over the past year as “investors searching for weaknesses” as liquidity drained from the system.