Defining Inflation and Why It Occurs - Part III

5. What Bond Yields Really Tell Us About Inflation

1. Bond yields signal inflation

Bond traders watch yields the way sailors watch the wind: changes in direction and velocity hint at the weather ahead. Nominal Treasury yields can be decomposed into two parts―a “real” yield that compensates for time value and risk, and an inflation-expectations premium. When the 10-year breakeven rate climbed to about 2.40 % in January   2025, up from a long-run norm closer to 2 %, it indicated that markets were pricing a longer stretch of above-target inflation^{Rowe Price—How high could the 10-year U.S. Treasury yield go?" target="_blank" rel="noopener noreferrer">[23]}. At the same time, real yields on 5- to 10-year TIPS hovered above 2.25 %, their highest level in more than 15 years^[24]. Higher real yields entice capital into the U.S.

and strengthen the dollar, but for domestic investors they raise the hurdle rate for everything from corporate borrowing to equity risk premia. Because rate-setting committees react slowly, traders with a one-year horizon often adjust portfolios before official policy shifts; Reuters reported a migration toward two- to five-year notes ahead of an expected “hawkish cut” late 2024^[25]. Thus, spot yields serve as a live poll of inflation psychology and a tactical compass for short-term positioning.

2. Using breakevens for 1-3 year positioning

For investors planning over a 1- to 3-year window, breakeven rates on 2- and 5-year TIPS are a powerful early-warning system. The 5-year breakeven, derived from the spread between nominal and inflation-linked Treasuries, compares closely with survey-based and modelled forecasts; a Cleveland Fed composite put expected 5-year inflation near 2.8 % at the start of 2025, while the nominal 5-year yield offered more than 2 percentage-points of real premium^[26]. When breakevens lurch higher, tacticians can: 1) shift toward shorter-duration corporates whose coupons reset sooner; 2) add inflation-protected securities or floating-rate notes; and 3) trim interest-rate-sensitive equities such as utilities. Conversely, a sudden drop in breakevens may justify extending duration before nominal yields follow suit. The logic rests on arithmetic: if you can lock in a 5-year nominal yield of 4.6 % while expected inflation is 2.5 %, your real return approaches 2.1 %—well above the Fed’s neutral estimate. Surveys reinforce the signal; the University of Michigan’s March 2025 poll found one-year inflation expectations jumping to 4.9 %, a full 0.6 percentage-points in a single month^[27]. Monitoring breakevens therefore allows investors to anticipate, rather than merely endure, inflation surprises.

6. Historical Cases of Hyperinflation and Deflation

1. When Money Burns: Three Hyperinflation Tales

From Weimar Germany’s 1923 currency collapse to Venezuela’s 2018 meltdown, history shows that hyperinflation ignites when governments lose both fiscal discipline and public trust. After World War I, the Weimar Republic tried to pay reparations by simply expanding its money supply; by October 1923 prices were doubling every 3.7 days and the monthly inflation rate touched 29 500 %^[28].

Zimbabwe repeated the pattern in 2008, when month-on-month inflation was estimated at 79.6 billion % and a 100-trillion-dollar banknote would not buy a bus fare^[29]. More recently, Venezuela’s annual rate rocketed to about 130 060 % in 2018 before partial monetary reforms curbed (but did not end) the spiral^[30].

Despite different geographies, each episode shared four trigger conditions: 1) war or political turmoil, 2) collapsing tax revenues, 3) heavy reliance on central-bank financing, and 4) a flight from the domestic currency into hard goods or dollars. Once inflation expectations became unanchored, conventional tools—raising policy rates or jawboning markets—proved powerless; only drastic steps such as currency redenomination, fiscal overhaul, and foreign-exchange backing restored stability.

2. Deflation’s Slow-Motion Squeeze

The opposite extreme—deflation—carries its own dangers for asset managers and policy planners. During the Great Depression, U.S. consumer prices fell about 24 % between August 1929 and March 1933 as money supply shrank nearly 30 %, intensifying debt burdens and bankruptcies^[31].

Japan’s “lost decades” illustrate the drag of protracted price declines: between 1998 and 2012 the consumer-price index slipped only 4 %, yet the persistent expectation of cheaper tomorrows stifled spending and kept real growth near 1 % for years^[32].

For short-term treasury or cash managers the lesson is clear: real returns look deceptively high during deflation, but nominal revenue streams shrink, default risk rises, and long-dated fixed payments become more costly in real terms. Prudent planners therefore simulate stress scenarios that include both a 50 %-per-month hyperinflation shock and a multi-year 1 %-per-year deflation glide path, ensuring hedges span inflation-linked debt, foreign-currency assets, commodity reserves, and—crucially—adequate liquidity buffers to avoid forced sales at distressed prices.

References

1. [23] T. Rowe Price—How high could the 10-year U.S. Treasury yield go?
2. [24] Schwab Asset Management—Treasury Bonds: Riding the Range
3. [25] Reuters—Bond investors brace for hawkish cut
4. [26] Investing.com—US 5-Year Treasury Yields Offer a Rare Premium
5. [27] MSM Times—Rising Treasury Yields Amid Growing Inflation Expectations
6. [28] CNBC—Worst Hyperinflations
7. [29] Wikipedia—Hyperinflation in Zimbabwe
8. [30] Wikipedia—Hyperinflation in Venezuela
9. [31] IMF—Historical Deflation Experiences
10. [32] BIS—Japan’s Growth and Deflation