Inflation, Deflation and Bond Market Returns

By Charlie Bilello

Inflation. Deflation.

Two words often heard in conversations about the bond market.


Because bond investors tend to demand higher yields in periods of higher inflation and lower yields in periods of lower inflation or deflation.

Looking at a long-term chart of yields and inflation, the relationship is clear.

Data Source: Federal Reserve Economic Data (FRED).

Not as clear from this chart is how bonds have actually performed during various levels of inflation. What has been the best environment for bond investors historically: high inflation, low inflation, or something in between? To answer that question, we need to take a closer look at the data.

Bond Returns During Various Inflation Regimes

If we segment calendar year changes in the Consumer Price Index (CPI) into quintiles, we observe the following:

  • The lowest nominal and real bond returns in high inflation environments (quintile 5).
  • The highest real bond returns in low inflation environments (quintile 1).
  • The highest nominal bond returns in periods of moderate inflation (quintile 4).

Data Source: BLS,

During years with the highest inflation (quintile 5):

  • Bonds generated their lowest nominal returns, 2.3% on average.
  • Many of the years represented in this quintile occurred during the 1970s (1970, 1973, 1974, 1975, 1976, 1977, 1978, and 1979) and early 1980s (1980, 1981).
  • Rising interest rates during this period (6.2% 10-year in 1969 to 15.8% 10-year in 1981) proved to be a significant headwind. When combined with high inflation, this resulted in the lowest real bond returns (-5.0%) of any quintile with only 11% of years showing a positive real return.

Data Source: BLS,

During years with the lowest inflation (quintile 1):

  • Bonds generated an annualized return of 4.3% with 89% of years posting a positive return. The real bond returns in this quintile, at 5.7%, were higher than the nominal returns due to negative annualized CPI.
  • Many of the years represented were during the Great Depression (1929, 1930, 1931, 1932) and the subsequent decade (1938, 1939, 1940). Deflation was the great concern during this period and bonds would act as one of the best preservers of wealth.
  • While nominal yields were low in this period, falling interest rates from 1929 (3.6% 10-year) to 1941 (1.95% 10-year) provided a tailwind to bond returns.

Data Source: BLS,

The best nominal bond returns for bonds have occurred during years with moderate inflation (3.1% – 4.7%) and falling interest rates:

  • After interest rates peaked in 1981, the combination of higher yields and falling interest rates for the remainder of the 1980’s provided a significant tailwind for bond investors.
  • From their peak of 15.8% in 1981, 10-year yields would end 1989 at 7.8%.

Data Source: BLS,

Where are we today?

With the CPI up 2.1% over the past year, we are right on the border of quintile 2 and quintile 3 in terms of inflation. Neither inflation nor deflation appear to be immediate concerns.

Data Source: BLS,

What are the concerns for bond investors? The a) lack of yield and B) threat of rising interest rates.

Entering the year at 2.40%, the 10-year Treasury yield was lower than 92% of historical data points since 1960. That’s important, because the single best predictor of long-term bond returns has been the starting yield.

In the short run, however, changes in interest rates can often be the more important driver. And thus far in 2018, interest rates have been rising at a rapid pace, moving from 2.40% at the start of the year to 2.90% today. That has sent bond prices lower, with the 7-10 year Treasury bond ETF (IEF) currently down 3.2% on the year.

The Last Five Years and the Next Five

Five years ago the 10-year Treasury yield stood at 1.88%. Over the subsequent five-year period, bond investors (in the Barclays Aggregate) would earn their lowest annualized return in history (at 1.72%).

Data Source: Bloomberg, Morningstar

With the rise in yields to 2.90% today, prospective returns have improved, but only modestly in a historical context. The average 10-year yield going back to 1928 is close to 5%.

With a below average yield, investors should expect a below average return, and a higher sensitivity to rising interest rates.

The only way out of this predicament? Pain, with rising rates leading to short-term losses but the promise of higher future returns to come. If given the choice, I’m guessing few investors would choose pain, but without it lower long-term bond returns are inevitable. No pain, no gain.

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