The end of the shock absorber

Sticky inflation, rising fiscal strains and weak growth are eroding the role of bonds

- SAHIL MAHTANI

YOU HOLD government bonds for their ballast: they're meant to rally when growth wobbles and equities sell off. That premise looks shaky these days. Medium-term inflation has not been durably contained; the fiscal arithmetic is deteriorating; and trend growth is too soft.

Put together, these forces push term premia up and keep stock-bond correlations higher than the pre-2020 norm. This blunts bonds' ability to offset equity drawdowns. So, do you need them at all?

Start with inflation. It has eased from its 2022-2023 peaks, but remains stubbornly above target in many advanced economies. In the UK, despite the lack of a feared wage-price spiral, inflation has been particularly sticky, with services inflation still hovering around 3.5% year-on-year.

Sticky inflation has been driven by regulation - for example, five years of fast-paced increases in minimum wages, excise duties, packaging rules, and loose fiscal policy, layered on top of higher global costs. That has interrupted disinflation, and kept long-dated gilt yields higher.

In the US, fears of persistent inflation have deferred policy easing, despite cooling growth momentum, providing one reason why long-term Treasury yields are near cycle highs.

Even in the euro area, where falling inflation has allowed a sizeable cutting cycle, disinflationary base effects have now played out and the bar is high for inflation not to rise into year-end 2025, especially with rising credit and money supply.