Inflation is making government debt more expensive

Rising recent inflation numbers have been spooking bond markets.

The yield on the 10-year Treasury rose to 4.47% on Wednesday. In fact, yields on government bonds have been rising for more than two months now. Treasury yields affect all kinds of consumer lending, but the amount they rise can also reveal a lot about what investors expect in the short term and over the long run.

Between the hot consumer price index and producer price index reports this week, bond investors have plenty of reasons to believe that inflation is getting uncomfortably high.

“What we’ve seen is investors pricing in higher long-term inflation, into what they want to receive from lending to the government,” said Luke Tilley, chief economist at Wilmington Trust.

He said investors expected inflation data to pick up this week, since energy prices have been rising ever since the war in the Middle East started.

But Tilley said the fact that inflation is rising in other categories, including trucking and transportation, is a big concern for the Federal Reserve. That’s because as long as consumers are willing to pay those higher prices, Tilley said the Fed wouldn’t necessarily want to cut interest rates.

“You would want to either hold them where they are, or raise them to tamp down on spending, essentially,” he said.

As a result, bond investors have been demanding higher yields, especially on short-term government bonds that are more closely tied to what investors think the Fed will do.

For example, Matthew Miskin, co-chief investment strategist at Manulife John Hancock Investments, said two-year Treasury yields have been picking up.

“That suggests, over the next two years, there will be a hike,” he said.

But interest rate hikes have consequences — they slow down the economy. And Miskin said that is being reflected by long-term bond yields.

“In terms of the longer end, it’s like if the Fed then hikes, or has to be more restrictive, then that’s not great for longer-term growth,” he said.

Miskin said that’s why yields on 10-year Treasurys, for instance, haven’t been rising as quickly as shorter-term yields. In other words, investors aren’t quite as worried about inflation over the long run as they are about inflation this year.

“An inflation shock today doesn’t really tell you anything about where inflation’s going to be in the period starting 10 years from now, or 20 years from now,” said George Pearkes, macro strategist at Bespoke Investment Group.

But Pearkes said long-term bond yields aren’t signaling doom, either. That’s because there are still plenty of factors that are boosting the economy, including consumer spending and business investment.

“What the bond market currently sees is a U.S. economy that’s very resilient,” Pearkes said.

And a resilient economy pushes yields higher, too.