Real yields take a dive (Oct 09)

The yield on inflation-indexed bonds may increase at the outset of a recovery if markets expect the authorities to raise interest rates in real – as well as nominal – terms. However, real yields have fallen sharply recently – especially in the UK. This may be because investors believe that by leaving interest rates on hold and expanding quantitative easing, the authorities are deliberately seeking to engineer inflation. However, monetary policy is only being left exceptionally loose in order to diminish the chances of deflation. Admittedly, inflation-indexed bonds could get a further fillip in the months ahead. Headline inflation is likely to rise as base effects linked to the past decline in energy prices unwind. Nonetheless, core inflation should continue to fall and drag headline inflation much lower again at a later date. At that point, real yields could start to rise again.