What is bond market telling us about inflation?

A month back, fears over growing inflation gripped the financial system across the globe. The global economy seemed overheated.

The global central banks were caught in a dilemma: economies had just crawled out of recession and needed some support; inflation is the last thing they would have wanted in such a scenario. To put it bluntly, central banks, across the globe, dance on a double-edged sword in their Monetary Policy Meeting: they must choose between the growth numbers and inflation numbers. These two variables, at most times, are inversely impacted. The central bank deals with it using interest rates: lower interest rate pushes growth; higher curbs inflation.

Such was the panic that the US Federal Reserve came out with a hawkish statement on interest rate. There are two types of impacts when the Fed – the central bank of the world’s largest economy – comes up with such a statement: it leads to outflow of foreign money from global markets, and it leads to recalibration of bond yields.

And it did reflect on bond yields – with one of the immediate aftereffects of the statement being the spike in bond yields. But before we go any deeper into bond yield rally, we need to understand how a bond market functions.

Simply put, bonds are the loans one offers to a corporation or government. The government bonds are considered as one of safest asset classes, as there is a sovereign debt guarantee associated with them. A bond's yield – or to say the return that one earns over a bond – is based on the bond's coupon payments divided by its market price; when bond prices increase, bond yields fall and vice versa. This happens because if central bank decides to increase interest rates, the bond's price (offering similar return as the current interest rates) would fall because its coupon payment becomes relatively less attractive. In such a scenario, debt-market investors start chasing new bonds with better and risk-free returns.

So, coming back to the US Fed’s hawkish statement on interest rates, it led to a decrease in bond prices and increase in bond yields. Since that made debt costlier for the government and corporations, Fed took a u-turn, and started to calm the nerves, later on.

However, COVID-19 spiked again – which had an impact on demand across the globe. The initial numbers – which denote a downward trend in retail sales – indicate reduction in the inflationary pressure. That is why bond yields have now drastically dropped in the past month: by 23 basis points (bps) in Germany and by 22 bps in France. In major economies, Australia suffered the steepest drop in bond yields, which dropped 40 bps in the last one month.

If anything, the retail sales number coupled with bond market movements, indicate that inflationary pressure is easing across the globe.