How will inflation expectations impact bond yields?

Inflation expectations amongst consumers have been increasing notably in many countries just recently. Indeed, it seems to have been inflation expectations that have accounted for a bigger proportion of the rise in bond yields recently, which might explain why the bond markets reacted so well when US CPI data came in below expectations on Wednesday. So, is this rise in expectations a flash in the pan, or something we should be worried about? The answer to this depends on which country we are talking about.

We all know that longer-term bond yields have been rising since the Fed started to cut rates last September. All sorts of explanations have been put forward for the unusual divergence between policy rates and long-term yields. In the US, these have included a resetting (higher) of market expectations about Fed policy, the stickiness of inflation, tariff concerns, and debt fears following Trump’s election win, and a future skew towards the issuance of longer-term debt over bills.

In the UK, budget concerns have been to the fore, as well as the recent pick-up in inflation. If we decompose the rise in 10-year gilt yields into real and inflation effects since the Fed started to tighten, we see that about two-thirds of the rise has reflected higher real yields. But if we just look over recent weeks, since the start of the year, this proportion has fallen, and now some 80% of the rise in nominal yields can be traced to inflation expectations (breakevens).

In short, inflation seems to have become a bigger factor in long-term bond yields. We can also see inflation angst in data releases relating to consumer sentiment. In the US, the latest University of Michigan 5-10 year inflation forecast rose sharply in December to 3.3% from 3% before, while in the UK, the Citi 5-10 year inflation forecast jumped from 3.6% in November to 3.9% in December—another large increase. Should we be worried that inflation expectations are moving in this way?

The Standard Bank’s view is that we should be more concerned about the UK than the US. Why is this? It relates to something we’ve talked about many times before, which is that we can’t really expect consumers to know where inflation is going to go in the future; many don’t know where it is right now. This bank suspects that consumers’ inflation expectations are largely driven by hysteresis; if they perceive that prices are high right now, they will assume this will persist in the future, and vice versa.

Hence, the recent uptick in actual inflation could have had a part to play here. If it continues, it might be a worry, but many analysts suspect it probably won’t. However, the caveat we have when it comes to the UK is that many surveys of businesses are suggesting that they are under increasing pressure to lift prices. This partly reflects the rise in labour costs following tax hikes in last October’s budget and a statutory rise in the minimum wage. The likes of the British Chamber of Commerce and the British Retail Consortium have all said that firms are under significant pressure to lift prices.

We regard these inflation expectations as far more useful than those of consumers. The latter are price takers, while businesses are price makers (or at least to the extent that they are able to set prices). Businesses might not have a better idea of the general inflation outlook than consumers, but they do know what will happen to their own prices, and if a very large proportion say that these could increase at a much faster pace, there has to be a good chance that this will happen. The upshot of this would seem to be that we should be much more fearful for the gilt market than the treasury market, and, indeed, this is the way the market has played things recently, albeit not necessarily for these reasons.

However, what we do have to watch out for is the possibility that US firms suddenly suggest that they are under significant pressure to lift prices should incoming president Trump launch the mother of all tariff attacks. Of course, many analysts can’t be sure that this will happen, and rumours are that Trump’s advisors prefer a modest and gradual approach to avoid significant price pressures. Nonetheless, risks do exist – in the US as well as the UK – and hence they still remain biased for higher long-term bond yields for now.