Bond markets show rising inflation is on the way, says finance expert

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Sign reading inflation ahead

A finance expert from the University of Stirling has warned that movements in the bond markets, which predicted last year’s recession, indicate that inflation is set to rise in the near future.

In a new paper, Professor David McMillan of the Stirling Management School argues that, while the stock markets are an accurate predictor during periods of economic growth, bond markets are  effective in forecasting economic turbulence – and he warns there may be trouble ahead.

Professor David McMillan

Professor David McMillan of the Accounting and Finance division of Stirling Management School.

Professor McMillan analysed changes in the bond market structure using the ten-year yield minus the three-month yield.

“We would expect the ten-year yield to be higher,” he said. “But when that flips and the three-month yield is higher, as it was before the 2008 financial crash and in late 2019, then it shows the markets expect a recession.”

 “If financial markets are working as they should, they should be able to indicate economic recovery, or not. But in the last year, during the pandemic, we have seen the stock markets doing very well while economies were not.”

Professor McMillan continued: “The stock markets tell us what’s going to happen when things are good, as they were during the 1990s, but the bond markets are a better predictor of potential economic difficulties (such as a recession or inflation), often reacting before policy makers do.”

He said that data from the US shows the gap between the three month and ten-year yields is widening, which means inflation is coming.

Graph image

Professor McMillan’s graphic shows a fall in the bond yield term structure pre-dates the fall in output growth.

“The difference between quantitative easing during the financial crisis and now is that, in 2009, the Government gave to the banks, who sat on the money. During COVID they have given to people, who will spend the money. So, inflation is expected, but to what extent will policymakers, investors and households bear it?

“In the US, inflation is now running at 4%, which is higher than expected, with the UK likely to follow (April’s inflation is 1.5%). Will it take off or will it be a blip? The bond markets suggest there is cause for concern. The question is, will the Bank of England do anything about it?

“They could relax the target inflation rate of 2% to allow the economy to catch up, but inflation is a problem if salaries don’t keep pace and for those who rely on a fixed income. Or they could raise interest rates, which causes a mortgage (and wider debt) problem and can choke off investment by firms.”

Professor McMillan’s paper, ‘When and Why Do Stock and Bond Markets Predict Economic Growth?’ is published in the Quarterly Review of Economics and Finance, Vol. 80, pp. 331-343

Predicting GDP Growth with Stock and Bond Markets: Do They Contain Different Information?’, International Journal of Finance and Economics, was published in August 2020


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