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  • Writer's pictureNicholas Pihl

What bonds are telling us about inflation

Updated: Oct 17, 2022

The big question on my mind these days is whether inflation is "transitory" or enduring. This matters because inflation tends to have a substantial impact on interest rates, which in turn affects stock and bond valuations. In turn, if interest rates rise substantially stocks and bonds may lose value. Whether they lose a lot or a little bit of value depends on how much rates rise, and how long those higher rates persist.

There are two schools of thought on this.

The first school, which has been the narrative of choice for the Federal Reserve, is that the inflation we are seeing today is transitory. Although we are in a brief spike, brought on by fiscal stimulus, supply chain issues, and other economic shocks of Covid, these pressures will ultimately fade. Fiscal policy will normalize, supply chains will get sorted out, and people will go back to work.

The second school argues that inflation tends to beget more inflation. Workers demand higher raises to pay higher costs of living, which means companies have to charge higher prices to stay profitable, which means the cost of goods bought by those workers has increased such that higher wages are required.

In addition, the second school has some doubts about the degree to which politicians will exercise greater restraint when spending other people's money, as well as whether the labor force will ever return to previous levels of productivity. The labor force faces demographic headwinds as many millennials scale back their work hours to raise kids, and boomers retire.

So is inflation here to stay, or will it return to lower levels? Instead of listening to what other people are saying, let's see what investors are doing with their money. Check this graph out.

This is the yield curve for US government bonds, which are presumed to be default free. What we see is that interest rates are higher than they were a year ago, and that the curve has flattened out substantially for maturities greater than 2 years. This means that while investors are demanding a higher return over the next 2-5 years, there isn't as much of a difference when you look into the more distant future.

One would think that if investors thought inflation was going to average 7% a year for the next 10 years, they wouldn't accept a 2.5% return on their bond investments. Losing a guaranteed 4.5% of your purchasing power each year just isn't worth it. Likely, they expect inflation to fall back towards 2-3% over time.

This implies good news for stocks. If longer-term bond yields stay where they are, investors are unlikely to rotate away from stocks in favor of bonds. Stocks are typically valued on a 5-10 year timeframe, on the basis that anything further out than this is too hard to make reasonable assumptions about. If the next best alternative is only yielding 3% and stocks promise to deliver 8% returns, valuations for stocks should be pretty stable.

But what would change this? Well, if we see those longer-maturity yields rise in that 10 year to 20 year range, then the market would be saying that inflation isn't going to revert to lower levels. In turn, this would lead to higher bond yields, and lower valuations for stocks.

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