The relationship between bond yields and inflation Essay

Inflation can be defined as a persistent or continuous rise in the general price level or, alternatively, as a sustained or continuous fall in the value of money. There are several things that need to be known regarding this definition. First, inflation refers to the movement in the general level of prices. It does not refer to the changes of relative prices between two products. Second, the prices are those goods and services, not from assets. Third, the rise in the price level must be somewhat significant and continue over a period longer than a day, week, or month.
The relationship between bond yields and inflation has been studied by some of the researcher long time ago. Theoretically, inflation is the worst enemy of bond because it decreased the purchasing power of investors and due to its high risk associated, investors demand for a higher yields to compensate themselves. Thus, a higher inflation will cause yields to increase, so they are positively related.
In the study Muharam (2013) one of the macroeconomic condition variables that influence government bond yields is inflation rate. The inflation rate has a positive effect on yield. High inflation suggests that macroeconomic conditions are not healthy and this will increase the risk for investors who invest their funds in government bonds, so investors demanded higher yields on government bonds. As a result of inflation, inflation risk on government bonds due to variations in the value of cash flows received by investors. The real value of cash flows received from fixed income investments such as government bonds will fall if there is inflation, therefore the price of government bonds will fall and the yield will rise (Muharam, 2013).
As suggested by Acker and Duck (2013), they found that the phenomenon of dividend yields puzzles become stable starting 1950s onwards. It concludes that the relationship between inflation and dividend yields are positive. This is consistent with the basic theory of inflation that said rise in inflation caused a positive effect on yields of bond. In addition, Bekaert and Engstrom (2010) found that the inflation influence the bond and equity yields positively when both variables move together at the same direction thus are said to be highly correlated with each other. It also means when inflation happens to rise during recession period, bond yields will increase followed by increase in the inflation risk components.
Duffee (2014) finds that the slope of the Treasury nominal term structure contains substantial information about the path of future inflation but very little information about real rates. Moreover, we know that inflation is highly persistent, thus shocks to inflation affect both short-maturity and long-maturity yields. Furthermore, evidence from macro-finance dynamic term structure models also suggests that shocks to short-term real rates are much less persistent. Estimates from these highly structured models typically imply that shocks to long-term nominal yields are primarily associated with inflation, either directly through shocks to expected inflation or indirectly through shocks to the compensation investors require to face inflation uncertainty.