Inflation may have receded from its peak, but investors would be unwise to assume that the threat has disappeared entirely. As geopolitical tensions escalate and the spectre of global trade wars looms, inflationary pressures could return, impacting everything from consumer prices to government borrowing costs. Nowhere is this more evident than in the yields payable on 10-year government bonds issued by the US Federal Reserve, the European Central Bank (ECB), and the Bank of England (BoE).
The risk of inflation’s resurgence
While central banks in major economies have worked aggressively to bring inflation under control, a range of external shocks threatens to undo their efforts. Potential supply chain disruptions stemming from geopolitical friction, trade restrictions, and conflicts in key resource-producing regions could reignite price pressures. The recent rhetoric from major economies, particularly the United States, suggests that protectionism is making a comeback, with tariffs and export restrictions likely to add fuel to inflationary fires by increasing the cost of goods and services to consumers.
Meanwhile, sustained fiscal stimulus, especially in the United States where significant infrastructure spending continues, adds another layer of concern. The combination of trade barriers and government spending raises the risk of a second wave of inflation that central banks may struggle to contain.
Government bond yields: The first line of impact
The bond markets serve as a key indicator of inflation expectations and investor sentiment. Yields on 10-year government bonds reflect the cost of long-term borrowing for governments, and they tend to rise when inflationary risks are elevated.
- United States – The 10-Year Treasury Yield
The 10-year US Treasury yield is a bellwether for global financial markets. Having surged past 5% in late 2023 before moderating, the yield remains overly sensitive to inflation data and Federal Reserve policy. Should inflation reaccelerate, markets may price in prolonged higher interest rates, pushing yields even higher. This would increase the cost of government borrowing at a time when fiscal deficits are already expanding. - Eurozone – The ECB’s Challenge
In the Eurozone, the ECB has been balancing the need to control inflation while maintaining economic stability in heavily indebted member states. Yields on German bunds, seen as the region’s safest asset, have been fluctuating, but a return of inflation would likely push them higher. More concerning is the impact on countries like Italy and Spain, where high government debt and rising borrowing costs could reignite concerns about debt sustainability. - United Kingdom – Bank of England’s Dilemma
The UK economy faces its own set of inflationary pressures, compounded by Brexit-related trade frictions and labour market constraints. The yield on 10-year UK gilts has remained elevated, reflecting persistent inflation risks and government borrowing needs. Any renewed inflation surge could force the BoE to maintain a restrictive stance for longer than expected, increasing the cost of refinancing the UK’s national debt.
What this means for investors
Investors cannot afford to be complacent in the face of these risks. A resurgence in inflation would mean:
- Higher interest rates for longer – Central banks would have little choice but to maintain restrictive monetary policy, dampening economic growth prospects.
- Increased market volatility – Bond yields moving sharply higher could trigger selloffs in equities and risk assets.
- Rising debt servicing costs – Governments with high debt burdens will face greater fiscal pressure, potentially leading to higher taxes or reduced public spending.
Staying ahead of the curve
To navigate these uncertainties, investors should consider:
- Diversification into inflation-protected assets – Treasury Inflation-Protected Securities (TIPS), commodities, and real assets like infrastructure can offer resilience.
- Selective fixed-income exposure – Shorter-duration bonds may be preferable in a rising yield environment.
- Global diversification – Exposure to economies less affected by inflationary pressures can help mitigate risks.
Conclusion
As geopolitical risks mount and trade tensions resurface, ELD Asset Management believes that inflationary pressures could complicate the outlook for government borrowing and financial markets. Investors must remain proactive, monitoring central bank policy and bond market movements to avoid being caught off guard. Complacency is not an option, staying prepared is the key to navigating an uncertain economic landscape.