Long term government bond prices have been on a slide since the beginning of 2021. As the economy improved and the S&P 500 continued to rise, it seemed logical that money would move away from the safety of bonds into risk assets such as stocks. This has a tendency to point to the ten-year Treasury bond as a barometer of risk appetite. The fear of inflation perked up as a new fiscal stimulus package that far exceeded any in the past was nearing completion in Washington, D.C. Suddenly, in late February, bond prices began to tumble, but so did stock prices. What’s going on?
How bond yields work: A bond’s yield has a tendency to move in the same direction as confidence. Bond yields move inversely to bond prices, so if confidence is on the uptick, bond prices will usually fall and bond yields increase. The opposite is true if confidence is falling. Bond prices are therefore countercyclical most of the time. What causes the uptick is money moving out of the bond market into risk assets such as stocks, and this movement is predicated upon a rise in confidence. Yields and interest rates seem to be the same, but they are not always equal. The interest rate is what is stated on the bond (or other debt instrument) in contractual form, meaning that is bond will pay 5.5% annual simple interest on the bond at par. The yield would be this interest amount divided by the amount the investor pays for the bond and not necessarily the par value. Some bonds do not have a stated interest rate but are sold at a discount. In those cases, the yield would be the amount of the discount divided by the amount the investor pays for the bond. Nominal long-term bond yields are rising, but real yields (inflation adjusted) are not rising as rapidly. This fact may keep the Fed from acting on increasing interest rates any time soon.
Corresponding market shocks: What happens if bond yields fall due to money being withdrawn from the market only instead of moving into the stock markets, it gets parked on the sidelines? This could be the cause of the shock that took place recently. Inflation fear might have driven it, but there are other causes that could be in play.
Causative factor number one—short term rate hikes: Another example of inflation fear is that the market for future short-term rates has begun pricing in rate hikes by the Federal Reserve as early as 1st quarter of 2023. If the economy does overheat at the end of the recovery period, this could mean higher interest rate hikes occurring sooner than anticipated. Such an event might roil the equity markets since valuations of stocks are often based on future earnings which take place in a calm, predictable interest rate environment.
Causative factor number two—falling short term bond prices: Government bonds are typically sold at auction as the government tries to achieve the best price possible to make the most out of the debt instrument. This would have a tendency to push the price of the bond up and the yield down. But during the inflation scare, government auctions for short-term bonds did not go well. The prices were not particularly high, and the yields started climbing.
Causative factor number three—dried up liquidity: Specifically, market liquidity being dried up means that individual trades could impact the market price. Generally speaking, liquidity refers to the amount of money available to trade on the part of buyers during any particular trading session. If there is little or no money available on the buy side, prices will fall and yields will climb.
Inflation’s labor market impact: The key to sustained, higher inflation may be in the recovery of the labor market. A rising labor market will cause inflationary pressures to some degree. So far, this process has been lagging as there are up to ten million workers who were gainfully employed before the lockdowns but have been out of work since. It can be painful to note that the Financial Crisis of 2007-8 was cured with what became known as “the jobless recovery.” This might be the blueprint for the Covid recovery as well.
Conclusions: With the economy working its way out of the Covid-19 crisis and the massive amount of fiscal stimulus being poured in, we could very well see more inflation driven bond market scares like the one in late February, 2021. The triple whammy of short-term rate hikes, falling short-term prices, and dried up liquidity could be an anomaly. But the ever-increasing overall amount of fiscal debt is a major force that complicates long-term recovery. Time will tell, but the improving economy and massive fiscal stimulus could push prices higher if only temporarily. Some supply chain shocks might still occur, but the quiet consumer is likely ready to do some spending which will boost GDP. Will there be a jobless recovery? Businesses will hire employees when they have more work for them to do—not necessarily because they have extra cash laying around. This might stymy political efforts to decrease unemployment, but the best effort would be to increase economic activity to support the demand side. And that’s what the giant stimulus package is largely designed to do. Mild inflation should not be feared. The Fed’s two percent target is a reasonable goal to achieve good economic growth and drive away the specter of deflation. Inflation provides energy to the economy. It is like fire—the right amount is heat and light. Too little and you freeze, too much and you burn up.
Sources: The Inflation Bogeyman, The Economist, March 6th, 2021.
Market Thoughts: What Do Rising Interest Rates Mean For Your Portfolio, Top Market Takeaways, JP Morgan Chase, 2021,