Growth, Inflation & Bond Yields

The below fact is stated in both readings 10 and 11 of the CFAI text. Why is this? Does someone understand it enough to give a practical example? What is a demand/supply driver?

When growth and inflation are primarily driven by aggregate demand, nominal bond returns tend to be negatively correlated with growth. When driven by aggregate supply, nominal bond returns are positively correlated.

Thanks

When demand is the driver, if growth increases, then demand increases, so bond prices go up, so yields go down.

When supply is the driver, if growth increases, then supply increases, so bond prices go down, so yields go up.

What is the relation between economic growth, inflation and bond yields?

First:

Economic growth can be driven by a higher aggregate demand (consumption + investment + public spending + net exports). In this scenario, inflation increases in the short term because there is a higher pressure (demand) on the set of goods and services available for sale. This kind of growth is healthy and is expected to create sustainable growth for the future. Practical examples of a higher aggregate demand can be (i) higher productivity of individuals lead to higher income, therefore higher consumption, (ii) lower taxes by government generates higher consumption or investments, (iii) the country becomes relatively more competitive against other countries and exports increase, therefore local consumption increases, etc.

Also, economic growth can be driven by a higher aggregate supply. In this scenario, inflation decreases in the short term because there is a higher quantity of goods and services available for sale bringing consumer prices down. This kind of growth is transitory and not expected to generate future growth. Practical examples can be (i) rice fields had and extraordinary production outcome this year, therefore the quantity of rice in the market has increased and its price decreased, (ii) factories making an extended black friday special offers and increase quantities sold but at lower prices, etc.

We know now the mechanism between inflation and each kind of economic growth driver.

What about bond yields? Bond yields are quoted at nominal interest rates. We know that:

Nominal Interest Rates = Real Interest Rates + Expected Inflation

Just replace the above analysis into that equation and see what happens:

  1. higher aggregate demand (growth) > higher inflation > higher nominal interest rates > lower bond prices > bond holders bear a capital loss in their bonds, therefore a lower nominal bond return

Correlation of growth with nominal bond returns under higher aggregate demand scenario = negative

  1. higher aggregate supply (growth) > lower inflation > lower nominal interest rates > higher bond prices > bond holders bear a capital gain in their bonds, therefore a higher nominal bond return

Correlation of growth with nominal bond returns under higher supply demand scenario = positive

Note that we are assuming that real interest rates and credit scores of bonds are fixed in the short term. It may change in the middle to long terms.

Hope this helps.

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^That makes perfect sense. Thanks for filling the gap!