Inflation and Interest Rates
As global monetary conditions tighten, investors may be concerned about the impact on bondholders when interest rates are rising. Although bond prices typically fall when rates rise, the yields on newly issued bonds will also increase. Reinvesting into higher yields over time can actually increase a bond portfolio's overall return potential. This can help offset the initial price impact of rising rates.
A yield curve is a line graph of the relationship between bond yields and time to maturity, with the U.S. Treasury curve the most widely used. The normal shape, or slope, of the curve is upward (from left to right), meaning yields usually rise with maturity. The curve can signal where investors think interest rates are headed, and historically the slope has been a worthy indicator of economic activity.
A sharply upward sloping, or steep, curve has often preceded an economic upturn. The assumption is that interest rates may rise significantly in the future. Investors demand more yield to buy longer-dated bonds in anticipation of accelerating economic growth and/or rising inflation.
Curve flattening can signal a slowdown. It often occurs later in a cycle when a central bank raises interest rates to restrain a rapidly growing economy and tamp down inflation. Short-term yields can rise to reflect rate hikes, while long-term rates may fall as expectations for inflation and growth moderate.
Inflation and interest rates are often correlated and at times can move in tandem. Rises in key inflation gauges such as the consumer price index (CPI) or personal consumption expenditures (PCE) can prompt investors to demand higher yields on longer-dated bonds to compensate them if inflation remains elevated. Persistent acceleration in inflation can also lead central banks to raise short-term policy rates to increase the cost of borrowing and rein in price gains.
By contrast, signs of decelerating inflation can push bond yields lower. Persistently below-target inflation can trigger a loosening of monetary policy, including a lowering of interest rates, with the aim of encouraging borrowing and spurring growth.
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All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed.
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