Is the Bond Market Wrong About Inflation?
Last year, 2022, was not kind to the bond market. In fact, it was the worst year ever for the U.S. bond market. according to Edward McQuarrie, professor emeritus at Santa Clara University. Inflation surged in 2022 and remains stubbornly high above the 2% target set by the Federal Reserve.
Will it remain high?
The bond market says “no.”
Could it be wrong?
Let’s start by examining what the bond market is telling us and conclude with a solution that will pay you and your clients to insure for the possibility of continued high, long-term inflation. Think of it as being paid to buy insurance.
I assumed that the surging interest rates in 2022 were mostly the result of high inflation with the CPI running at 8% for calendar year 2022. Because of the inverted yield curve, markets said inflation would come down and the Fed would lower the overnight Fed funds rate that it controls. It does not control intermediate and long-term rates; markets control that. Case in point, between 12/31/2014 and 11/8/2019, the Fed raised the Fed funds rate by 1.5 percentage points and the 10-year Treasury bond yield declined. Markets did not believe high inflation was imminent.