Brianna J. from Las Cruces, NM asks: Good Afternoon Mr. Zacks, I’m writing with a question about interest rates and inflation. I’ve always heard that when inflation goes up interest rates usually go up as well. But the opposite is happening now. Can you explain the disconnect?
Mitch’s Response:
Thanks for sending in your question, Brianna. Let me first offer a visual to readers who may not be following the inflation and interest rate dynamic as closely as you. The blue line in the chart below represents the 10-year U.S. Treasury bond yield while the red line is charting the consumer price index excluding food and energy. It’s clear to see the two lines have diverged greatly over the last few months:
Interest Rates are Falling While Inflation Goes Up
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As you mention in your question, we would generally expect interest rates to rise as inflation goes up, as investors would demand a higher yield to compensate for the reduced purchasing power that comes with inflationary pressure. But we’re seeing just the opposite today.
I think there are two factors to consider when explaining the divergence between inflation and interest rates. The first is the distinct possibility that inflation may be transitory in nature, which remains the assessment of the Federal Reserve currently. The thinking here is that the surge of demand has created temporary disruptions in supply chains and in the labor markets, which is putting upward pressure on prices over the short term. The Fed believes supply will eventually catch up with demand, and these pressures should abate with time. Falling interest rates today may be signaling this eventual outcome.
Another possible explanation is that too many investors piled into the view that longer duration Treasury bond yields would surely head higher, on the heels of rising inflation and a too-hot economy. Betting that Treasury yields would move higher is also a bet that Treasury prices would fall, and data suggests many institutional investors made bets against Treasuries this year-to-date. This set the table for short covering as investors kept buying bonds, which ultimately kept downward pressure on yields.3
At the end of the day, the move in Treasuries is likely a combination of many factors, which likely include – in my view – a more modest outlook for inflation and the expectation that the U.S. economy will settle into a post-pandemic steady growth rate sooner than later.
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Disclosure
2 ZIM may amend or rescind the guide “Helping You Manage Market Volatility” for any reason and at ZIM’s discretion.
3 Wall Street Journal. August 9, 2021. https://www.wsj.com/articles/treasurys-big-rally-gets-help-from-skeptics-of-low-rates-11628501581?mod=hp_lead_pos4
4 ZIM may amend or rescind the guide “Helping You Manage Market Volatility” for any reason and at ZIM’s discretion.
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