WAR OR INFLATION: THE BOND MARKET CASTS ITS VOTE
Markets have been pulled between two global risks: war in Eastern Europe and inflation. The former is a geo-political risk with unknown economic consequences. The latter is more recognizable and has direct consequences for monetary policy and economic growth. For stocks, both risks can be expected to be bad news, so it’s not surprising that stocks have mostly sold off recently. But for bonds, the outlook would be quite different for the two cases.
Inflation, of course, is bad news for bonds. With real rates across the world in such negative territory, the prospect for continued high inflation and/or rate hikes by central banks would be considered bad news. But war usually benefits bonds. Political uncertainty of this magnitude typically drives a need for liquidity, which causes government bonds to rally. So the behavior of governments bonds would tell us which risk the bond market thinks is higher: (1) the risk of Russia invading Ukraine, or (2) continued high inflation and rate hikes from central banks, especially the Fed.
The path of bond yields shows us that the bond market clearly believes that inflation is a bigger risk than a potential war in Eastern Europe.1 The upward march of interest rates has barely paused in recent weeks, even after the US and UK governments said that invasion was likely any time and the US began evacuating diplomatic personnel from Kiev last week. The bond market might be wrong, of course. But that’s where its casting its vote right now.
1For those who are new to markets, bond prices and bond yields move in opposite directions. So, a rise in bond yields means that demand for bonds is lower and bond prices are falling.
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