How Does Inflation Affect the Yield Curve?

Under normal market conditions, the yield curve is upward sloping—yields get higher as the curve moves out to longer-maturity bonds. Investors typically demand higher yields to justify holding bonds for longer periods.

But a steep curve—high yields on longer-maturity bonds relative to shorter maturities—also means you need to watch out for higher inflation rates.

Stronger economic growth and general prosperity often generate more demand for products. If supply can’t increase enough to meet the demand, prices will rise. Many factors can trigger higher rates of inflation, including rising labor costs, soaring energy and other commodity prices and global supply chain issues.

So, how do you know what the shape of the yield curve is telling you? Here are some tips to help you—and insights about what it might mean for fixed-income investments.

The Dynamics of Inflation and Loss of Purchasing Power

Inflation is an increase in prices across the economy. Money declines in value when it can't buy as much as before; in other words, you lose purchasing power.

In periods of high inflation, prices can rise dramatically and consumers can quickly lose purchasing power. On the other hand, if inflation is low or negative, people may wait to buy things if they think prices will go down more. Reduced business activity may cause lower investment and layoffs.

It’s a tricky balance for the Federal Reserve (Fed) to manage.

The Interplay Between Inflation and Interest Rates

Central banks adjust interest rates to either rein in unruly inflation or boost a slow economy.

In times of high inflation, policymakers will likely raise interest rates to slow the economy and bring down prices. When it costs more to borrow money, demand for goods and services tends to decrease and inflation slows.

If the economy is slowing, policymakers might lower interest rates to encourage more spending and borrowing. This creates more demand to stimulate the economy.

How Does Inflation Affect Bonds?

Investors want their money to grow and beat inflation when they buy securities like bonds. Otherwise, they will realize negative “real” returns (i.e., the returns after subtracting the rate of inflation).

Here’s a simple example of nominal and real returns (which doesn’t account for any price changes).

Economic Data and the Yield Curve

To understand why the yield curve looks the way it does, you need to consider other key stats about the economy. Here are three closely watched economic indicators:

1. Federal funds interest rate
   The Federal Open Market Committee (FOMC) sets this lending rate to banks . This rate has an impact on other interest rates and shapes the short end of the yield curve. The FOMC has eight regularly scheduled meetings each year to review economic and financial conditions and its interest rate policy.
   

2. Consumer Price Index
   The Consumer Price Index  is a backward look at the change over time in the prices consumers paid for a basket of goods and services. People keep a close eye on this index to spot any troubling trends that could lead to bigger problems for consumers and the economy.
   

3. Gross domestic product
   The gross domestic product (GDP)  is a backward look at a country’s total economic output of goods and services. The world views the U.S. GDP as a global economic barometer.
   
   High positive growth can mean a hot economy, a precursor to inflation. In contrast, a few quarters of negative growth could indicate a weakening economy and recession.

Steep Yield Curves, Inflation and Portfolios

When the yield curve begins to steepen, it’s a good time for a portfolio checkup to see if you’re prepared for inflation.

How much money is in cash-equivalents investments? Chief investment officer Richard Weiss says that while sometimes they offer attractive yields in the short term, cash-equivalents are not designed to keep up with the average rate of inflation over time.

Bonds that factor in inflation, such as Treasury inflation-protected securities, may be a good option. These inflation-protected securities, issued by the U.S. government, have principal that adjusts with changing inflation.

Bond laddering can be another approach. It involves purchasing a mix of short-, intermediate- and longer-maturity bonds.

• If interest rates rise, investors may benefit from higher rates when your short-term bonds mature and they reinvest the money.

• If interest rates fall, some long-term bonds in portfolios may be locked into receiving higher rates than the market.

Of course, this approach requires investors to know about the underlying securities and the factors that affect their performance.

And don’t forget how stock allocations may help portfolios outpace inflation. Investing in the growth of different companies and the economy in general gives investors who can tolerate the risk higher return potential than bonds and cash.

Maintaining a diversified portfolio of stocks, bonds and other securities may help you adapt to whatever challenges arise—even spikes in inflation.