A man holds an iBonds subscription document over his head during heavy rain in Mong Kok on June 1. Photo: Nora Tam
by Kerry Craig
by Kerry Craig

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.

In theory, when inflation goes up, the price of bonds falls and the yields on those bonds rise. However, what is happening now is somewhat perplexing as bond yields have been falling even as inflation is rising. Is the bond market actually broken?
In the midst of the pandemic, central banks stepped into the government and corporate bond markets to ensure they functioned correctly. Central bankers did not want a repeat of the credit crunch during the 2008 global financial crisis and were quick to address any perceived dislocations that would prevent the adequate supply of credit and the healthy functioning of the financial system. 

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.

However, since March, the yield has fallen to below 1.5 per cent at times. This appears counterintuitive, given concerns surrounding just how transitory inflation will be – if anything, yields should be rising as inflation picks up. 
The sharp upswing in consumer prices in April followed by another increase in May went well beyond consensus expectations. The May inflation report showed a 5 per cent year-on-year rise in prices and a 3.8 per cent rise in core inflation, excluding food and energy prices, the highest level since 1992. The US Federal Reserve targets a 2 per cent rate of inflation.
Despite these inflation figures, bond markets really seem to believe inflation pressures will be temporary following weeks of consistent messaging from the US central bank. Certainly, the details of the inflation report show the impact of what could be considered one-offs, such as the rise in used car prices. This might have led the market to be less assertive in its inflation views. 

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. 

Coronavirus hammers US economy – 2020 was worst year since 1946

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. 

However, the trend for inflation and bond yields is even higher. The US economy is performing much better than expected and will create more persistent inflationary pressures. The distorting effects of unemployment insurance benefits will come to an end by September, and business surveys in the United States already indicate that employers are willing to pay higher wages to attract workers.
This should mean a continued improvement in the labour market and rising wages. Additionally, those segments of the economy badly affected by the pandemic such as hotels, airlines and other travel-related services are likely to experience an increase in demand and prices, which can add to inflation pressures.

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.