
Consumer prices paid by city dwellers in the US rose more than 7% last month and more than 9% in April on an annualised basis. If this keeps up the rest of the year, it will be the highest inflation rate the US has experienced since the 1980s. But fear not, say some investors and the Federal Reserve, the bond market isn’t worried. Yields fell over the last week and remain low by historical levels, even after rising on the back of Jay Powell’s speech. And if markets aren’t worried, maybe we shouldn’t be either. But there are reasons to worry about rising prices, and the bond market shouldn’t offer any comfort.
In theory, bonds are a barometer of future inflation. If inflation is high for the next 10 years, that would lower the return on a 10-year note. So investors want to be compensated for what they think inflation will be or for the risk involved when the outlook is uncertain. If either expectations or inflation risk increase, so should bond yields, but the opposite has happened in the last few weeks.
That means one of two things: Inflation will moderate, or bond prices aren’t accurately reflecting inflation risks.
Historically, bond yields have not been very good at predicting inflation.
In the last 70 years, bond yields rarely rose ahead of inflation, going up only after inflation takes hold. One study indicated that past inflation trends were a better predictor of bond rates than what future inflation turned out to be.
Does this mean bond traders are wrong? Not necessarily. It may just reflect that inflation is unpredictable and bond traders don’t know any more about the future than the rest of us.
All they have is the past data and current prices to make their predictions, too. So when inflation suddenly spikes — as it has in the past — bond traders are as surprised as everyone else.
Bond markets are even less predictive now. Even if bond traders did have a magic ability to predict the future, they don’t entirely determine bond prices. In the first quarter of 2021, the Fed’s expanding balance sheet accounted for more than 70% of the growth in outstanding government debt.
In 2020, the Fed, the government, banks and insurance companies accounted for more than 64% of new government debt.
—Bloomberg