Is the bond market wrong about inflation?

People queueing at Al Capone&#039;s soup kitchen in the 1930s © Bettmann Archive/Getty Images

The US has suffered the equivalent of the first three years of the Great Depression in just three months

(Image credit: © Bettmann Archive/Getty Images)

published 7 August 2020

US GDP had its worst fall on record in the second quarter. It shrank by 9.5% from the previous quarter, a 32.9% slump in annualised terms. “That is... the equivalent of the first three years... of the Great Depression accelerated into just three months”, says Tim Price of Price Value Partners.

GDP is a backward-looking indicator, but US weekly jobless claims have increased for two weeks running as the virus has forced renewed closures in southern states, says Alexandra Scaggs for Barron’s. The bond market is now sending a “warning signal” about the recovery, says Giles Coghlan on fxstreet.com. The yield on US ten-year Treasury bonds hit its lowest level since early March last week, while three- and five-year yields hit new record lows. Bond yields move inversely to prices, so falling yields imply gains for bondholders.

The bond rally is perplexing for two reasons. Firstly, governments have issued vast tranches of new debt to pay for the pandemic, which would ordinarily cause their borrowing costs (implied by bond yields) to rise, not fall.

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The US budget deficit hit $864bn in June, a figure Dan Morehead of Pantera Capital says surpasses “the total [US state] debt incurred from 1776 through the end of 1979” in nominal terms. In 2020 a country can rack up “two centuries of debt in one month”. Bondholders have central-bank purchases to thank for keeping yields low.

Secondly, the bond rally suggests that markets are sanguine about inflation, says Tommy Stubbington in the Financial Times. That’s partly because monetary stimulus after the financial crisis did not deliver the inflationary wave many predicted. Yet the recent gold rally suggests that concern about rising prices is growing. If the gold buyers are right, the bond market has got it “very wrong”.

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Alex is an investment writer who has been contributing to MoneyWeek since 2015. He has been the magazine’s markets editor since 2019.

Alex has a passion for demystifying the often arcane world of finance for a general readership. While financial media tends to focus compulsively on the latest trend, the best opportunities can lie forgotten elsewhere.

He is especially interested in European equities – where his fluent French helps him to cover the continent’s largest bourse – and emerging markets, where his experience living in Beijing, and conversational Chinese, prove useful.

Hailing from Leeds, he studied Philosophy, Politics and Economics at the University of Oxford. He also holds a Master of Public Health from the University of Manchester.