Relationship Between Inflation and Bond Prices

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The expectation of inflation will cause the price of a bond to drop. A bond is a claim to the receipt of a fixed amount of money at maturity. If you expect inflation over the course of, for example, the next 10 years, then you will expect that the payoff on your 10-year bond will not be worth as much at that time as its nominal value indicates. This expectation will reduce your, and everybody else's, demand for that bond, reducing the price at which it can sell.

Arithmetic

  • Consider as an example a 10-year bond with a face value of $1,000. You may expect there will be an constant rate of inflation over the next 10 years of 2 percent. In that case, you would expect the payout in 10 years will be worth roughly $832 in present dollars. (Some investors might simply multiply 2 by 10 years, get 20, and figure the payout will only be worth 80 percent of $1,000, or $800. However, if inflation takes away 2 percent every year, then it is taken from a decreasing base. In the second year, for example, it is no longer eating away at $1,000, but at $998; 2 percent of $998 isn't $20, it's $19.98.)

Yield

  • The simple statement about the relationship of inflation and bond prices, then, is that the expectation of the former will depress the latter. Anything that depresses the price of a bond increases its yield, because the two have an inverse relationship.

History

  • The market's inflationary expectations sometimes prove dead wrong. For example, in the late 1970s, the United States financial markets were pricing a high level of inflation into the whole range of fixed-income investments, because high rates of inflation had come to be the norm. But on Oct. 6, 1979, the Federal Reserve announced a new policy --- the Fed would target the money supply, with disinflation as its explicit goal, and would allow interest rates to find their own level.

    In the following week, bond prices plummeted. But over the following year, bond prices recovered. One way of looking at the situation is to say the market at first expected the move to fail to stop inflation and priced in drastically higher expectations, thus producing the October 1979 collapse in bond prices. The market gradually decided it was in error and readjusted its prices accordingly.

Anomaly

  • On October 2010, observers noticed an anomaly. Inflationary expectations and bond prices were both rising. The market was aware of the Federal Reserve chairman's willingness to use "quantitative easing" (which is inflation) as a tool for stimulus. Yet bond prices were on the way up.

Expectation

  • The widespread expectation, as expressed, for example, by Dan Norcini at the precious-metals oriented blog, Jim Sinclair's Mine Set, was that this could not last. The Fed itself had been buying bonds and keeping its prices up, but in time the Fed would have to choose between an inflationary scenario (with falling bond prices) or a deflationary course. Take quantitative easing out of the picture, Norcini wrote, and the bond market consists of "the enormous supply and the lackluster demand."

References

  • Photo Credit Jeffrey Coolidge/Digital Vision/Getty Images
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