The Correlation Between Rising Bond Yields and Inflation Risks

In recent weeks, the bond market has been making headlines with the 10-year yield experiencing its biggest weekly jump in seven weeks. This has led to concerns about the correlation between rising bond yields and inflation risks.

In this article, we will break down the factors influencing bond yields and the potential impact on inflation.

Understanding Bond Yields

To understand the correlation between rising bond yields and inflation risks, it is essential to first grasp the concept of bond yields. The bond market is considered a risk-free asset, and when people buy U.S. Treasuries, it is generally considered a flight to safety.

When the demand for Treasuries increases, the price of the bond goes up, and the effective yield on the bonds goes down. Conversely, when people are willing to take on more risk, they sell Treasuries, and the yield goes up.

Recent Trends in Bond Yields

Over the past two months, yields on longer-term U.S. Treasuries, such as the U.S. 10-year, have risen by over 40 basis points. This is due to a lack of demand for Treasuries, as investors can get similar yields from stocks in a single day. This trend is especially true when considering factors like inflation.

Inflation and Bond Yields

Inflation is a crucial factor in bond yields, as it can erode the purchasing power of the interest earned on the bond. For example, if Akiko, our esteemed co-host, expects inflation to be 2.5% over the next 10 years, the nominal interest earned on a 10-year security would be erased.

This is where Treasury Inflation-Protected Securities (TIPS) come in. TIPS are government bonds that adjust for inflation, providing a real payout to investors. When inflation expectations increase, the demand for TIPS increases, causing the yield to go down.

Recent Trends in TIPS Yields

Recently, the yield on a U.S. 10-year TIPS has gone up, but it has plateaued over the course of the week. This dynamic suggests that investors are becoming less concerned about inflation, despite the recent rise in bond yields.

Alternate Explanations for Rising Bond Yields

While inflation is a significant factor in rising bond yields, there are other explanations to consider. One such explanation is changes in time preferences. Investors may rotate from longer-duration to shorter-duration Treasuries due to the Federal Reserve’s actions.

The bond yields serve as a proxy for borrowing costs, and on the short end, if the Fed keeps short-term interest rates low, investors may follow suit, pinning down shorter-term Treasury yields and showing no love for 10-year yields, which could take the yield up.

Another explanation is supply and demand. With more government debt being issued for more government spending, a flood of supply could turn off investors if they don’t find those securities attractive.

Additionally, there are concerns about regulatory issues at banks, which are some of the biggest buyers and holders of U.S. government debt. Rules like the Supplementary Leverage Ratio determine their ability to absorb government debt.

Conclusion

The correlation between rising bond yields and inflation risks is a complex issue with many factors at play. While inflation is a significant factor, changes in time preferences and supply and demand can also impact bond yields.

As the bond market continues to make headlines, it is essential to keep in mind that there is no singular reason for bond yields moving up. Instead, a combination of factors is at play, and understanding these factors can help investors make informed decisions.

As the Federal Reserve continues to navigate the post-pandemic economic recovery, how will their actions impact the bond market, and what implications will this have for inflation and investment strategies?