InvestorQ : What do falling global bond yields signal coming inflation?
vaishnavi mhatre made post

What do falling global bond yields signal coming inflation?

Rohan Bhadani answered.
2 weeks ago
Since you have mentioned global bond yields, I’ll explain with an example of US bond yields, which generally set the trend for global bond yields. We know that bond yields and prices are inversely related to each other. The twin factors that affect a bond’s price are inflation and changing interest rates. A rise in either interest rates or the inflation rate will tend to cause bond prices to drop. Inflation and interest rates behave similarly to bond yields, moving in the opposite direction from bond prices.

Rising prices over time reduce the purchasing power of each interest payment a bond makes. Let’s say a five-year bond pays $400 every six months. Inflation means that $400 will buy less five years from now. When investors worry that a bond’s yield won’t keep up with the rising costs of inflation, the price of the bond drops because there is less investor demand for it.

The Fed’s decisions on interest rates can also have an impact on the market value of bonds. The Fed plays an active role in trying to prevent inflation from spiraling out of control. When the Fed gets concerned that the rate of inflation is rising, it may decide to raise interest rates. When the Fed raises its target interest rate, other interest rates, and bond yields typically rise as well. That’s because bond issuers must pay a competitive interest rate to get people to buy their bonds. New bonds paying higher interest rates mean existing bonds with lower rates are less valuable. 

Just the opposite happens when interest rates are falling. When rates are dropping, bonds issued today will typically pay a lower interest rate than similar bonds issued when rates were higher. Those older bonds with higher yields become more valuable to investors, who are willing to pay a higher price to get that greater income stream. As a result, prices for existing bonds with higher interest rates tend to rise.

In its latest review, the Fed said it expects inflation to climb this year as a reopening of the U.S. economy and a reduction of Covid-19 cases rekindles demand for travel, dining, and a variety of other goods and services. But Fed officials have said they anticipate the 2021 rise to be transient and to fall short of its new goal of averaging 2% over time. The central bank wants to see prices rise faster than 2% for some time to make up for periods of lower inflation before making significant changes to monetary policy.

What these global bond yields signal is a delay in expectations of an interest rate hike by the Fed, as inflation still remains within the range that the central bank is comfortable with.