In the debate over inflation, bond yields are the key to figuring out market direction.
Specifically, central bank policy primarily involves manipulating bond yields to obtain the results they need. That, in turn, affects the stock market, currency prices, and commodities.
But, what does this mean in practice?
Generally, with higher inflation, the value of currency depreciates. So, a common hedging tactic is to invest in something that preserves its value over time, like gold. If inflation rises in the near term, gold prices can rise.
On the other hand, should inflation rise, then bond yields could also rise to offset the loss from inflation and attract investors.
It’s not all market-driven
At least, that’s how it’s supposed to work in theory, as the cost of risk is accounted for in a higher investment premium.
For example, in the US, we saw rising bond yields at the start of the year. This was because investors accounted for the possibility of higher inflation during the recovery.
However, yields have since turned lower as investors priced in the possibility that the Fed will keep rates low, and will keep buying up treasuries to keep bond yields lower.
So, even though there is the expectation of higher inflation, the Fed is preventing an increase in the premium, to account for the risk.
The broader impact
If inflation is higher than the interest rate, then whoever owns bonds is losing money.
Because of this, they will likely prefer a different asset. Gold is the most convenient, but other commodities, such as copper and petroleum, are also routinely used as hedges against inflation.
Most commodities are priced in dollars. Thus, if the dollar experiences increased inflation without yields rising, then we could expect commodity prices to rise.
Another hedge against inflation are stocks, since they have intrinsic value, and aren’t eroded by inflation.
Additionally, they pay a dividend, which is somewhat insulated from inflation. This means that if prices are increasing, then presumably the company will raise prices to maintain margins. If the company can maintain its profit margin, it can keep paying the same value of the dividend, even if there is inflation.
In fact, companies with high levels of debt could find distinct advantages in a high inflation environment.
It’s all about return on investment
A substantial portion of investment is done on margin.
So, if interest rates go up, it “costs” investors more. If inflation rises, but interest rates don’t, then it “costs” investors less to invest.
Therefore, if we see higher interest rates, we generally expect lower stock prices, and commodity prices to level out. And overall, currencies become more likable investments.
If bond yields remain low, then we can generally expect higher risk stocks (companies with higher p/e ratios) to perform better, along with commodities. Thus, currencies with higher interest rates become more interesting.
Another important thing to note is the effect of higher inflation on volatility. Specifically, in the past when there has been higher inflation, there has been higher volatility in all the markets.
This is because investors need to find higher yields to offset the increased “cost” of holding cash, and investments have a bigger impact on profitability, so careful management is necessary. Higher volatility generally implies more profit opportunities for traders.
However, it’s important to keep a close watch on what’s going on in the markets, especially with bond yields.
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Tuesday, 06 Jul, 2021 / 12:23