Flagging yields amid rising inflation raise fears the bond market is broken
- Rather than a signal to intervene, the fall in yields might be a sign that messages around the transitory nature of inflation are starting to sink in
- The onus is on the US Federal Reserve to justify its accommodative stance and lean into its guidance that it will tolerate higher inflation before raising rates
Inflation is the enemy of the bond investor. Rising prices erode the purchasing power of the fixed coupon payments earned from holding corporate or government debt.
Even as bond yields have fallen in recent weeks, this is not a sign of unwanted dislocations or the need for central banks to once again intervene. In fact, it might be that the messages around the transitory nature of inflation are finally starting to get through.
In the first quarter of this year, yields on government bonds rallied quickly as investors priced in the economic rebound and the higher rate of inflation that would come with it. The yield on the 10-year US Treasury almost doubled between January and March, rising from 0.93 per cent to 1.74 per cent.
Moreover, the disappointments in the US labour market are probably also affecting sentiment on inflation pressures. The “million jobs a month” growth in the US labour market has failed to materialise. The average of 478,000 jobs being added each month this year is still impressive, but perhaps less so when there are still more than 9 million unemployed Americans and the path to full employment appears a little further out of reach.
Technical factors are often put forward to explain situations when markets do not behave as expected. Repositioning by large institutional investors and closing of short duration positions in the lead-up to potential tapering announcements might have created enough demand for US Treasuries to push prices higher.
The bond market is not broken. Yields are likely to start their ascent again as the prospects of inflation remain strong in the coming months, albeit not at the current 5 per cent, as some of the transitory forces will pass. The risk is that this could sharply boost bond yields rather than seeing a more market-friendly, gradual rise.
The onus will be on the Fed to prove that inflation really is transitory, to justify its accommodative policy stance and lean into its guidance that it will tolerate higher inflation before raising interest rates, to calm market expectations and keep borrowing costs low.
Kerry Craig is a global market strategist at JP Morgan Asset Management.