Macroscope | 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

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

Published: 2:30pm, 18 Jun 2021Updated: 2:30pm, 18 Jun 2021

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.

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.css-1m2rp1p{color:#34b8b5;}Macroscope | Flagging yields amid rising inflation raise fears the bond market is broken

Macroscope | Flagging yields amid rising inflation raise fears the bond market is broken