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Wednesday, February 19, 2020

Inflation Is NOT The Most Significant Factor Determining Bond Prices — Brian Romanchuk

One of the pieces of pseudo-science that floats around in popular discussion of bonds is the belief that bond investors are deadly afraid of inflation. In particular, bonds "lose money" every time the Consumer Price Index rises -- which is most months, in most developed countries. As far as I can tell, this is the legacy of some Economics 101 textbook story that has been passed on from "expert" to "expert" over the decades.
The correct answer is that nominal yields largely reflect the expected path of the short-term nominal policy rate, and is thus a reflection of the central bank's "reaction function." (At this point, some people will jump in and start going on about the term premium. However, unless we using an obviously dysfunctional term premium model, the term premium is only a small deviation from the fair value determined by rate expectations.)
The advent of inflation-linked bond markets adds some extra qualifications to the previous statements. (My previous book discusses the inflation-linked markets.) If a bond investor is overweight inflation-linked bonds, they can get a big fat bonus if inflation turns out higher than expected. However, the beliefs about bond investors that I am discussing here were formed in an era when inflation-linked markets did not exist, so economics textbook writers were free to write in whatever campfire ghost story they wished.... 
Bond Economics
Inflation Is NOT The Most Significant Factor Determining Bond Prices
Brian Romanchuk

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