How do increases in inflation expectations affect bond prices?

Increases in inflation expectations typically lead to a decrease in bond prices. This relationship is rooted in the fundamentals of bond valuation and the impact of inflation on future cash flows.

When investors expect inflation to rise, the purchasing power of the fixed interest payments that bonds provide diminishes. This means that the real return (the nominal return adjusted for inflation) on bonds becomes less attractive. As a result, investors often seek higher yields to compensate for the anticipated decrease in purchasing power. In the bond market, this leads to a decline in demand for existing bonds that offer lower fixed interest rates, causing their prices to fall.

Furthermore, when inflation expectations rise, central banks may respond by increasing interest rates to combat inflation, which can further depress bond prices. As interest rates rise, newly issued bonds typically offer higher yields, making older bonds with lower rates less desirable, leading to a further drop in their prices.

Thus, the connection between rising inflation expectations and declining bond prices is a critical concept in understanding how economic conditions influence fixed-income securities.