In economic theory, inflation is generally regarded as having an adverse impact on government debt because it erodes the purchasing power of a bond’s future cash flows, making coupon payments and the returns on principal less valuable amid an uptrend in pricing pressure. That is why evidence of inflation usually leads to selling in bonds, pushing yields, which move opposite to prices, higher. 

However, lately, it seems the bond market is not following the script many had expected this summer, which would have seen interest rates rising on the back of a booming economy. Instead, yields on longer-dated Treasuries have been holding the line, and even pushing lower, in the face of what could be viewed as mounting confirmation of persistent inflationary pressures.

Indeed, the most closely watched US interest rate metric – the 10-year Treasury note yield ended below the 1.20 per cent level on Monday and continued to trade below this level for the rest of the week, a level where it last traded in February. Meanwhile, the spread between the two- and 10-year yields, arguably the clearest bond market judgement of reflation, was back down below 100 basis points this week, having cancelled out its rise since February. All this is happening at time when a measure of the cost of living, the so-called Consumer Price Index (CPI) surged in June, driving the pace of inflation to a 13-year high of 5.4 per cent, as the economy attempts to recover from the Covid pandemic.

Economists and analysts have provided several reasons to try to explain the rationale behind the current low yields in a rising inflation environment. One is that strong demand for corporate bonds is pushing Treasury bond yields lower. Another theory says the negative interest rate environment in both Europe and Japan is boosting the demand for US debt, since the US offers positive returns. Moreover, investors may be seeking the shelter of government bonds over rising fears that a return to “normality” could be quite a bit further out than many had hoped a few months back due to the rapid spread of the covid variant worldwide. This explains, in part, the moves seen on the markets over the past few days, with equities and long-term yields both registering some meaningful setbacks.

A third reason behind the bid for bonds could be that we have now reached peak inflation after having already reached peak opening. In effect, the five-year Treasury Inflation-Protected Securities (TIPS) breakeven is down 19 basis points from the recent high at a time when the Fed’s Weekly Economic Index peaked a few weeks ago, in lockstep with yields.

The final and perhaps the most bizarre reason for this unusual relation between bond prices and inflation is that the Fed may be engineering negative yields so that the cost of servicing the rising US Treasury debt will start to shrink. In effect, with interest rates at such a low level, the cost of paying interest on the federal government’s huge debt already exceeds the Defence Department’s annual budget which is no mean feat for the US economy.For now, it looks certain than neither Fed Chairman Jerome Powell nor Treasury Secretary Janet Yellen will try to constrain the money supply with significantly higher interest rates that might impede economic growth. 

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

For more information visit https://cc.com.mt/. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.

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