The Inflationary Bogeyman Rears His Head

There are few things that investors fear more than inflation. For many, this is an abstract fear, since few equity investors have seen a period of sustained inflation during their investing careers, but it remains an existential concern nonetheless. Inflation erodes the prices of most financial assets, and investors dislike anything that erodes their assets. With the Federal Reserve actively seeking an inflation level of about 2%, and commodity prices rebounding – including some like copper and lumber approaching multi-year highs – this a concern that investors must address.

The 10-year Treasury note is perhaps the best indicator of the market’s inflationary fears. After a startling run-up in price (remember that bond yields are the inverse of bond prices), we can see that the rally has begun to fade. We can see from the chart below that even though bond prices have dipped, they are still well above pre-Covid levels. One might look at the chart below and wonder what the fuss is all about.

Prices of Rolling (Continuous) 10 Year Treasury Note Futures

(Click on image to enlarge)

Prices of Rolling (Continuous) 10 Year Treasury Note Futures

Source: Interactive Brokers

As I write this, the 10-year yield is about 1.34%. By any historical standards that is not a worrisome level. Yet it was enough for Christine Lagarde, the President of the European Central Bank (ECB) to state that the ECB was “closely monitoring” sovereign bond yields. The rise in US Treasury yields was putting pressure on yield in Europe – apparently enough to justify a statement from the Continent’s main central banker. Our 10-year notes rallied in response, having recouped much of the decline that had pushed rates to nearly 1.40% this morning.

It is important to remember why bond prices reflect inflationary fears. It is typical to see longer-term bonds trade with higher prices than their shorter-term counterparts. There are a few reasons for this. The first is a liquidity preference. Investors are willing to accept lower yields for instant access to their money. This is how banks can offer such low-interest rates on checking accounts. Another is credit risk. Less can go wrong for a company if there is less time until a bond matures. Of course, this is not a major concern for Treasury investors, since the US government is typically seen as the best credit available. The final reason, and the one most relevant here, is inflationary expectations. If bond investors view their future payments as being rendered less valuable because of inflation during the ensuing years, they will demand higher interest to compensate for those inflationary expectations. That is what we are beginning to see in the bond market now.

1 2
View single page >> |

Disclosure: FUTURES TRADING

Futures are not suitable for all investors. The amount you may lose may be greater than your initial investment. Before trading futures, please read the CFTC ...

more
How did you like this article? Let us know so we can better customize your reading experience.

Comments

Leave a comment to automatically be entered into our contest to win a free Echo Show.