This easy-to-read guide explains how inflation affects bond return, a related Fed policy, and the difference between real and nominal returns. The Impact of Inflation on Bonds. Full frame of US Patriot Treasury Bonds. TIPS "treasury inflation protected securities" currently provide very little upside ( return), but that exact statement can be made about just about. A large and expanding literature explores the relation between nominal bond yields and inflation. Ang and Piazzesi () make a particularly important.
If you sell a bond before its maturity date, you may get more than its face value; you could also receive less if you must sell when bond prices are down. The closer the bond is to its maturity date, the closer to its face value the price is likely to be.
Though the ups and downs of the bond market are not usually as dramatic as the movements of the stock market, they can still have a significant impact on your overall return.
They move in opposite directions, much like a seesaw. The opposite is true as well: When bond prices rise, yields in general fall, and vice versa. What moves the seesaw? However, other factors have an impact on all bonds. A rise in either interest rates or the inflation rate will tend to cause bond prices to drop. Inflation and interest rates behave similarly to bond yields, moving in the opposite direction from bond prices. If inflation means higher prices, why do bond prices drop?
The answer has to do with the relative value of the interest that a specific bond pays. Rising prices over time reduce the purchasing power of each interest payment a bond makes.
Bonds, Interest Rates and the Impact of Inflation - Business in Greater Gainesville
Why watch the Fed? Inflation also affects interest rates. The Fed takes an active role in trying to prevent inflation from spiraling out of control. When the Fed gets concerned that the rate of inflation is rising, it may decide to raise interest rates.
To try to slow the economy by making it more expensive to borrow money.
How will rising bond yields affect gold as an asset class?
For example, when interest rates on mortgages go up, fewer people can afford to buy homes. That tends to dampen the housing market, which in turn can affect the economy. When the Fed raises its target interest rate, other interest rates and bond yields typically rise as well. New bonds paying higher interest rates mean existing bonds with lower rates are less valuable.
One is in currency like the US dollar, the euro or the yen. Second is in precious metals like gold and silver. If we invest in gold, we are not getting any interest.
Bonds, Interest Rates and the Impact of Inflation
In fact, it costs money to store physical gold while another alternative of holding gold is in demat form like ETFs namely the SPDR Gold shares charge expenses which also add to the cost. The alternative of holding your wealth is in saving account or in low risk bonds which will give you interest.
So, when interest rates rise, yields on savings accounts and bonds also rise which makes a gold less attractive investment as an opportunity cost of holding your wealth in gold also rises. An Interest rate is a key element that helps determine the intrinsic price of gold.
The other elements are storage cost and insurance. Combine all these elements and you will get the price of the commodity. After that how the price moves depends on micro drivers like the movement of US Dollar and fundamental factors like demand and supply.
The relation between gold and yield is better explained in a chart.
EconomPic: The Relationship Between TIPS, Treasuries, and Inflation
If we look at from the yeargold was increasing steadily while US Year Treasury yield was decreasing. However, in last 10 years, the correlation between two assets has become stronger. The last 10 year chart shows the peak and trough in gold and year US Treasury yield.
Historically we have seen that gold thrives when yields are trading at the bottom. In fact, we can predict the top and bottom of gold by looking at the year yield chart.
Now the question is why 10 year yield and not 2-year or 5-year yield.