Persisting Threat of Inflation for Bond Interest Rates

Persisting Threat of Inflation for Bond Interest Rates

In an unexpected turn of events, the US Federal Reserve has initiated a series of short-term interest rate cuts. However, yields on US ten-year Treasuries have defied this trend, increasing by half a percentage point to 4.2% over the past month. This rise in longer-term interest rates for instruments like the US 10-year Treasuries and UK 10-year gilts is influenced by several factors.

Firstly, reduced expectations for further rate cuts have led to a flattening but rising yield curve, pushing up longer-term yields. Market participants have lowered their expectations for the amount and speed of central bank easing or rate cuts, as seen in the U.S. where the probability of multiple Fed cuts by year-end has declined significantly.

Secondly, persistent or rising inflation expectations contribute to higher long-term yields. In the U.S., break-even inflation rates have edged higher, reflecting increased inflation protection demands. Inflation concerns make investors demand higher yields to compensate for eroding purchasing power.

Thirdly, uncertainty surrounding geopolitical or policy risks adds risk premia to yields. This uncertainty can increase bond yields as investors seek compensation for potential volatility or inflation surprises.

Fourthly, even in a context of central bank cuts aimed at stimulating growth, if investors anticipate sustained growth or less severe economic slowdown than previously feared, longer-term rates may rise. This reflects expected higher future interest rates and inflation.

Fifthly, supply and demand dynamics in bond markets can also play a significant role. In markets like UK gilts, high volatility and differing demand-supply conditions can push yields higher even amid overall central bank easing trends.

Despite these rate cuts, ten-year yields in both the US and UK are close to five-year and 30-year yields. If inflation matches the Fed's target of 2%, a 4.2% yield will give an after-inflation return in line with the long-term average. The typical term premium for holding longer-term bonds has been surprisingly modest in the US since 1977.

If inflation turns out to be much lower than expected, buying 30-year bonds could be the right call. However, investors are worried about structurally larger deficits and higher inflation in both the US and UK, which could contribute to yield increases. The US runs a large deficit and the deficit is expected to remain large regardless of the election results. The UK is also heading towards higher public spending.

In conclusion, the rise in longer-term interest rates despite central bank rate cuts is a complex interplay of factors, including market expectations, inflation, economic growth outlook, monetary policy uncertainty, and bond market dynamics. Investors should closely monitor these trends to make informed decisions.

This article was first published in the website's magazine.

\n\nReferences:

1. Investopedia
2. Federal Reserve Bank of St. Louis
3. Bank of England
4. Financial Times
5. Contrary to the US Federal Reserve's short-term interest rate cuts, bond yields for both US 10-year Treasuries and UK 10-year gilts have increased, indicating a shift in finance and personal-finance strategies among investors.
6. Increased inflation expectations, geopolitical or policy risks, and supply-demand dynamics in bond markets, among other factors, have contributed to the rise in longer-term interest rates, challenging traditional strategies for investing in long-term bonds.

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