What bond yields can tell us about inflation expectations

The bond market has had a lot to digest as the war in the Middle East has progressed over the last several weeks.

Demand for government bonds can give a lot of information about how nervous investors are, since they often buy Treasurys in times of geopolitical turmoil. But the bond yields investors are demanding to be paid can also reveal how much inflation investors expect. And the war is certainly putting pressure on prices.

Yields on short-term government debt — as in, Treasurys that mature in a couple years or less — are heavily influenced by what traders expect the Federal Reserve to do with interest rates.

“Traders have concluded the Fed is very likely on hold at least through this year, and perhaps through next year as well,” said Chris Low, chief economist with FHN Financial.

He said short-term yields are more or less in line with the Federal Funds Rate, which the Fed sets. That’s a signal that traders don’t expect any changes, Low said, because the war is causing inflation to pick up.

“The Fed would, in fact, like to cut rates probably another half percent at some point,” he said. “But they’re not going to do it until inflation is materially lower than it is now.”

Then, there’s medium-term yields — Treasurys that mature in five or seven years.

“If you are investing in 5-year notes, or 7-year notes, longer-term inflation expectations become a bigger concern,” said John Canavan, lead analyst at Oxford Economics.

He said even though the war is pushing up inflation in the short term, longer-term inflation expectations are actually tamer.

“And what we have seen, since the prospects of an end to the war grew a little bit more optimistic, (is) a decline in those inflation expectations — a notable decline,” Canavan said.

That kind of optimism has also helped to relieve pressure on long-term bonds that mature in 10, 20, or 30 years.

“With a less drawn-out conflict, or a resolution to the conflict, defense spending doesn’t increase as significantly, and budget deficits don’t jump as big as they would have otherwise,” said Randy Vogel, head of fixed income at Wilmington Trust.

That means the Treasury Department wouldn’t have to flood the market with new debt and pay higher interest rates to attract borrowers. But Vogel said things could change if the war escalates.

“That would most likely mean higher budget deficits, more defense spending,” he said.

It could also mean higher interest rates on long-term Treasury bonds, and on credit card debt, mortgages, and all the other kinds of debt influenced by bond yields.