Effect of Inflation on Bonds
While inflation has hardly taken center stage among our economic woes of late, there are some credible voices in economics who are already warning of its dangers down the road. Since the FED has already locked itself into rock-bottom interest rates for the foreseeable future, if the economy does not surprise us with a great rebound in the next few years the Fed will have to resort to its one remaining tool, i.e. an expansionary monetary policy, adopting more aggressive quantitative easing, debt monetizing, and other stimulating (but also inflationary) measures. In short, the FED will have to print more money.
At that time, the threat of inflation will be real once more. It’s advisable to reacquaint ourselves in advance with the basic effects of inflation so that when it comes, we’re prepared to deal with the consequences. Today we’ll be looking at how this would affect the bond market specifically. The following are some things you should know about the effect of inflation on bonds:
The Problem with Inflation
As we saw in a previous article Impact of Inflation on Bonds Part 1, the main problem with bonds in an inflationary environment (more so than stocks, which would tend to adapt) is that a discrepancy begins to open up between the rate of return on bonds and the rate of inflation. So for instance, if your bonds are yielding 2% for the year, but prices are inflating at 3.5%, your statements would still show a supposed gain of 2%, but this would represent an actual loss in terms of purchasing power.
Another risk is that if serious inflation were unleashed, the Fed would have no choice but to try to counteract it by raising interest rates, after years of driving them down. The result of this would be rising bond yields in tandem with falling bond prices, the end result of which is a loss of principal value for current bondholders. [Read more...]