Bond yields and inflation are linked through one simple mechanism: the real return an investor expects. When inflation rises, the fixed payments from existing bonds become worth less in purchasing power, so investors demand higher yields on new bonds to compensate.
Why higher inflation means higher yields
Central banks typically raise policy interest rates to cool inflation. New bonds are issued at these higher rates, making older bonds with lower fixed coupons less attractive. To sell an older bond in the secondary market, the price must fall until its yield matches the market.
Example: a 10-year bond
Imagine you hold a 10-year bond that pays 3% per year. If newly issued bonds now pay 5%, no buyer will pay full price for your 3% bond. Its price drops until the total return to maturity equals roughly 5%.
Key takeaway
Inflation erodes the future value of fixed payments. Therefore, bond yields move up as inflation expectations rise, and existing bond prices move down. The relationship is not always one-to-one, but the direction is reliable.