The central banks mostly raise interest rates to counter the effect of rising inflation which causes bond yields to rise and prices to fall.
In its first monetary policy review of the FY18-19, RBI (Reserve Bank of India) lowered its inflation projection for the first half of the ongoing fiscal to 4.7-5.1 percent on sharp moderation in food price rise and possibility of a normal monsoon. The new projection is much lower than the 5.1-5.6 percent range in the first half of ongoing fiscal. Even though it takes a variety of factors to affect the movement in the bond yields, one of the most frequently blamed culprits is threats of inflation.
In economics, inflation is defined as any hike in general price level of goods and services in an economy during a period of time.
In the monetary policy review yesterday, RBI said that a normal monsoon and waning effects of HRS (house rent allowance) will keep inflation around the central 4 percent mark of the flexible target range of 2-6 percent in FY19. These forecasts pumped up the bond market that was already on an upbeat mode past RBI’s decision to spread HTM losses of banks over four quarters. Bond yields plunged 16 basis points on Thursday. The price of the bonds drop as there is less investor demand for them. Any rise in inflation causes bond prices to fall. The central banks mostly raise interest rates to counter the effect of rising inflation which causes bond yields to rise and prices to fall.
The timing of cash flows of bonds is very important including its maturity term. If investors think that inflation is on verge of an increase, bond yields and interest rates rise to cover the loss in the purchasing power of future cash flows.