The share market has been described by Warren Buffett as a “manic depressive”. The same can be said of financial markets generally I reckon, and it’s certainly been evident lately. Just a year ago investors were worried about depression and deflation with bond yields and share markets plunging and now they are worried about overheating and inflation with bond yields rising rapidly and causing agitation in share markets! The bond sell off gathered pace over the last week or so. From their lows in March-April last year, 10-year bond yields have now increased by around 0.9% in the US and 1% Australia. (Don’t forget that a rise in bond yields means a fall in bond prices or a capital loss.)

The rebound has been driven by increasing confidence in economic recovery, helped by optimism that vaccines will allow a sustained reopening spurred along by policy stimulus with concerns that more US fiscal stimulus risks overheating the US economy and much higher inflation, ultimately forcing the Fed to tighten earlier than planned. Bond markets are also sniffing out an inevitable spike in inflation in the months ahead as a result of the deflation of year ago dropping out of annual inflation measures, higher energy costs, higher raw material costs generally and supply bottlenecks pushing up goods prices. This will likely see annual headline inflation measures rise to around 3.5% to 4% by mid-year in the US and Australia.

The concern is that the back in bond yields will put pressure on share markets that have rallied partly on the back of low interest rates and bond yields. So how big a worry is it? This note provides some context and the implications for investors.