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How Does Inflation Affect the Yield Curve?

An upward-sloping yield curve usually signals a growing economy. But it also can be a sign that higher inflation is on the horizon. Here are some tips to help spot the difference.

01/09/2024
Curved building.

Key Takeaways

A steepening curve usually signals a strong economy. But it can also be a sign that higher inflation is on the horizon.

The real rate of return can tell you if your investments are keeping pace—and hopefully exceeding—the inflation rate.

Knowing how the yield curve relates to inflation may help investors prepare for rising costs and adjust portfolios.

Under normal market conditions, the yield curve is upward sloping—yields get higher as the curve moves out to longer-maturity bonds. Investors typically demand higher yields to justify holding bonds for longer periods.

But a steep curve—high yields on longer-maturity bonds relative to shorter maturities—also means you need to watch out for higher inflation rates.

Stronger economic growth and general prosperity often generate more demand for products. If supply can’t increase enough to meet the demand, prices will rise. Many factors can trigger higher rates of inflation, including rising labor costs, soaring energy and other commodity prices and global supply chain issues.

The yield curve is a visual depiction of the yield differences between bonds of the same credit quality but different maturities. The most used and referenced yield curve is the U.S. Treasury yield curve.

So, how do you know what the shape of the yield curve is telling you? Here are some tips to help you—and insights about what it might mean for fixed-income investments.

The Dynamics of Inflation and Loss of Purchasing Power

Inflation is an increase in prices across the economy. Money declines in value when it can't buy as much as before; in other words, you lose purchasing power.

In periods of high inflation, prices can rise dramatically and consumers can quickly lose purchasing power. On the other hand, if inflation is low or negative, people may wait to buy things if they think prices will go down more. Reduced business activity may cause lower investment and layoffs.

It’s a tricky balance for the Federal Reserve (Fed) to manage.

The Interplay Between Inflation and Interest Rates

Central banks adjust interest rates to either rein in unruly inflation or boost a slow economy.

In times of high inflation, policymakers will likely raise interest rates to slow the economy and bring down prices. When it costs more to borrow money, demand for goods and services tends to decrease and inflation slows.

If the economy is slowing, policymakers might lower interest rates to encourage more spending and borrowing. This creates more demand to stimulate the economy.

How Does Inflation Affect Bonds?

Investors want their money to grow and beat inflation when they buy securities like bonds. Otherwise, they will realize negative “real” returns (i.e., the returns after subtracting the rate of inflation).

Here’s a simple example of nominal and real returns (which doesn’t account for any price changes).

Let’s say an investor owns a 10-year, $1,000 bond with a 4% coupon, and the inflation rate is 2%. The nominal yield is 4%.

However, the real return considers inflation. The difference between the nominal return and inflation rate (4% minus 2%) is the real return, 2%.

If inflation rises to 5%, the bond investor still gets the nominal rate of 4%. However, the real return decreases to -1% (4% minus 5%). When inflation rises, the real return on existing bonds may decline.

If the Fed raises interest rates to combat inflation, newly issued bonds will reflect higher yields. Therefore, if the investor sells the 4% bond in the secondary market, the price will drop because newer bonds offer better yields.

What’s more, many investors may be expecting the Fed change its interest rate policy. The Fisher effect, named after economist Irving Fisher, shows how increases in expected inflation rates steepen the yield curve.*

Economic Data and the Yield Curve

To understand why the yield curve looks the way it does, you need to consider other key stats about the economy. Here are three closely watched economic indicators:

  1. Federal funds interest rate
    The Federal Open Market Committee (FOMC) sets this lending rate to banks. This rate has an impact on other interest rates and shapes the short end of the yield curve. The FOMC has eight regularly scheduled meetings each year to review economic and financial conditions and its interest rate policy.

  2. Consumer Price Index
    The Consumer Price Index is a backward look at the change over time in the prices consumers paid for a basket of goods and services. People keep a close eye on this index to spot any troubling trends that could lead to bigger problems for consumers and the economy.

  3. Gross domestic product
    The gross domestic product (GDP) is a backward look at a country’s total economic output of goods and services. The world views the U.S. GDP as a global economic barometer.

    High positive growth can mean a hot economy, a precursor to inflation. In contrast, a few quarters of negative growth could indicate a weakening economy and recession.

Stay up to date with our latest views in Investment Outlook.

Steep Yield Curves, Inflation and Portfolios

When the yield curve begins to steepen, it’s a good time for a portfolio checkup to see if you’re prepared for inflation.

How much money is in cash-equivalents investments? Chief investment officer Richard Weiss says that while sometimes they offer attractive yields in the short term, cash-equivalents are not designed to keep up with the average rate of inflation over time.

“Although ‘cash is king’ when returns for other asset classes are negative, money markets are virtually the only guaranteed losing investment in real terms (that is, net of inflation) over any longer-term horizon.”

Bonds that factor in inflation, such as Treasury inflation-protected securities, may be a good option. These inflation-protected securities, issued by the U.S. government, have principal that adjusts with changing inflation.

Bond laddering can be another approach. It involves purchasing a mix of short-, intermediate- and longer-maturity bonds.

  • If interest rates rise, investors may benefit from higher rates when your short-term bonds mature and they reinvest the money.

  • If interest rates fall, some long-term bonds in portfolios may be locked into receiving higher rates than the market.

Of course, this approach requires investors to know about the underlying securities and the factors that affect their performance.

And don’t forget how stock allocations may help portfolios outpace inflation. Investing in the growth of different companies and the economy in general gives investors who can tolerate the risk higher return potential than bonds and cash.

Maintaining a diversified portfolio of stocks, bonds and other securities may help you adapt to whatever challenges arise—even spikes in inflation.

Feeling Behind the Curve?

Learn more about inflation strategies and talk through your options with us.

Garner, C. Alan. The Yield Curve and Inflation Expectations, Economic Review, September/October 1987.

Diversification does not assure a profit nor does it protect against loss of principal.

This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

Generally, as interest rates rise, the value of the securities held in the fund will decline. The opposite is true when interest rates decline.