Bond markets hint at more inflation and an uncertain economy

Treasury yields have surged to multi-decade highs, potentially signaling prolonged inflation and two scenarios (good and bad) for the economy.

For the first time in 16 years, yields for the 10-year Treasury note eclipsed 5% last week. The last time the 10-year yield was this high was just before the subprime mortgage crisis snowballed into a full-blown financial meltdown.

Six months ago, the 10-year rate was 3.54% while it was a mere 0.58% three years before that during Covid.

On the inflation side, that means the market is betting on higher prices to stick around or even climb higher. That's because bond yields typically rise during inflationary periods.

On the economy side, higher yields are hinting at one of two potential outcomes.

If inflation persists and the economy grows, the Fed may be more likely to continue raising interest rates to cool down growth. If, however, inflation persists and the economy slows down, the central bank will face a tough dilemma.

Scenario 1: High bond yields signal higher inflation and a growing economy

In a speech at the Economic Club of New York Luncheon last week, Fed chair Jerome Powell said lower inflation is a “favorable development,” but he cautioned: “We cannot yet know how long these lower readings will persist, or where inflation will settle over coming quarters.”

Bond markets seem to agree with Powell that “inflation is still too high.” The 10-year's steep run-up to 5% shows a conviction in bond markets that inflation at 3% or more is going to stick around longer, maybe even worsen.

That might not be all bad news, though. It might signal markets’ confidence that the economy is going to keep growing at a fast clip.

Strong job numbers from September seem to support this scenario. The U.S. economy added 336,000 workers to nonfarm payrolls, far exceeding expectations.

Meanwhile, the unemployment rate remained stable at 3.8%, indicating the economy may not be giving out just yet.

Scenario 2: Bond markets expect higher inflation and a slowing economy

The problem with rising yields is that they can be a double-edged sword.

On one hand, they indicate a strong economy. On the other hand, higher rates have historically preceded economic downturns, making the economy’s future even murkier.

If the economy slows but inflation sticks around as bond markets predict, the economy could tip into 1970s-like stagflation, according to analyst Ed Yardeni of Yardeni Research.

And while Wall Street appeared to rule out stagflation during the summer, a growing number of analysts are now having second thoughts.

Generali Investments published a research note on September 28 that said: “By early summer, investors looked increasingly confident that the global economy was escaping the plague of stagflation. They are having a second thought—rightly so.”

The following day, Mel Lagomasino, CEO of WE Family Offices, told CNBC’s “Squawk Box” that she expects higher interest rates if the Fed needs to tackle stagflation. “I think that the big bogeyman out there is stagflation, that we get into this spirit of high inflation and low growth,” she said.

This would likely leave the Fed with a tough choice to make between saving jobs with lower interest rates or fighting inflation with higher rates.