Betting on Inflation Through the Bond Market

A conventional theory about US Treasury bonds is that when there is uncertainty about inflation, the yield curve should get steeper because investors demand a higher premium for the risk of holding long-term bonds, as opposed to less vulnerable short-term ones.

However, recent evidence suggests this yield curve effect may not be happening and this has now been confirmed in research by Harrison Hong, David Sraer and Jialin Yu, who also offer an explanation: during inflation uncertainty, optimistic investors may be betting on the outcome, leading to bonds becoming overpriced and yields to then flatten in the long run.

“Uncertainty among inflation forecasts can be taken as a proxy for actual heterogeneous expectations among bond investors in the same way that disagreement among stock analyst forecasts are used as a proxy for disagreement about a stock’s expected earnings,” the authors said.

“Since a bond’s sensitivity to inflation rises with maturity, a bond’s sensitivity to disagreement about inflation also rises with maturity. Even small disagreements are amplified into large differences in expectations about the pay-offs of the long-term bonds. In contrast, when it comes to the expectations of payoffs for short-term bonds, even larger disagreements about inflation are dampened.”

The uncertainty and disagreement have different effects on different investors. Optimistic investors expect low inflation, so they are motivated to speculate and buy long-term bonds from pessimistic investors, who expect high inflation and want to be short.

Pessimistic investors also face constraints in acting as a counter-balance to optimistic investors. Some may face institutional restrictions to shorting, which is the case for mutual funds. Hedge funds do not have such restrictions but may be side-lined because they face non-trivial Treasury bond lending fees.

The upshot, say the authors, is that “long-term bonds will be held by the most optimistic investors in the market when inflation disagreement is large and short-sales constraints are binding. This then leads to more over-pricing for long-term compared to short-term bonds and a flatter yield curve as a result. We term this phenomenon an inflation-betting effect.”

Using a range of data, including US consumer sentiment on inflation (to measure inflation uncertainty), Treasury bond supply and the average excess returns of Treasury bonds, among other variables, they confirm that disagreement about inflation expectation does indeed lead to lower expected excess returns for long-term bonds relative to short-term ones, when the aggregate supply of bonds is low.

The results have implications for debates over the low interest rates set by the Federal Reserve bank.

“A number of prominent economists have argued that these rates are potentially destabilising since they encourage speculation by financial institutions in search of a minimum amount of yield. Yield is typically obtained by buying longer-term bonds for duration, in the context of Treasuries, and to stretch for risk in other asset classes like junk bonds.

“Our inflation-betting effect provides some support for the hypothesis that if institutions reach for yield by speculating on long bonds, then their expectations about how long interest rates will stay at a low level becomes important. Disagreement about inflation will then be likely to play a role in explaining their reach-for-yield behaviour,” the authors said. These effects will need to be explored further in future research, they added.

HONG, Harrison

Adjunct Professor of Finance

YU, Jialin

Academic Director, HKUST-NYU Stern MSc in Global Finance, MSc in Investment Management (Full Time), Associate Professor