What Rising Treasury Yields and Falling Gold Prices Tell Us About the Federal Reserve

A few readers may notice an apparent tension between two recent articles I published.

In my September 14 article, I noted that oil price spikes associated with the Iran conflict appeared to be contributing to higher inflation expectations. Because nominal Treasury yields incorporate expected inflation, it is reasonable that Treasury rates would rise as investors reassess the inflation outlook.

However, a rise in inflation expectations does not automatically imply that inflation fears have become widespread or persistent. That was the focus of my September 30 article. The inflation measures and expectation metrics reviewed there, including Median CPI, 3-Year Expected Inflation, and the 5-Year Breakeven Inflation Rate, continue to suggest that inflation expectations remain relatively well anchored by historical standards.

At first glance, these two observations might look like a paradox: If inflation expectations are rising enough to push bond yields up, why wouldn’t gold rally on the same inflation fears?

The short answer is that inflation expectations and inflation fears are related concepts, but they are not the same thing. But the more detailed and nuanced answer lies in foundational economic concepts developed in the 1970s: central bank credibility and the difference between expected and unexpected policy.

Economists Thomas Sargent and Neil Wallace wrote a paper in 1975 called “’Rational’ Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule.” Sargent and Wallace argued that when market participants understand and anticipate a Central Bank’s reaction plan (they called this “systemic policy”), they adjust prices, contracts, and interest rates smoothly. In contrast, severe market dislocations and panics occur only when the Central Bank loses control and delivers unexpected surprises or allows inflation expectations to become unanchored.

In another paper called “Rules Rather than Discretion: The Inconsistency of Optimal Plans” published in 1977 by economists Finn Kydland and Edward Prescott, they argued that Central Bank credibility does not simply mean investors believe what policymakers say today. It means investors believe policymakers have the institutional discipline and incentive structure to stick to their commitments over time, specifically, keeping inflation under control rather than trying to engineer short-term economic booms.

In short, when markets trust a Central Bank’s long-term resolve, an increase in inflation is treated as a routine economic cycle rather than a structural crisis.

A picture is worth a thousand words. Look at the graphic below, as it will crystalize the two market dynamics that I highlighted in my two previous blog posts.

Why Treasury Yields Rose (The Bond Market Perspective) 

Treasury bonds pay fixed dollar payouts. If investors expect everyday prices to rise slightly over the coming years, they naturally demand higher interest rates on their bonds to offset the eroding purchasing power of future cash flows. Because investors viewed this rise in inflation as an expected, standard cyclical move, the bond market did what it was designed to do: smoothly adjust nominal yields higher to compensate for anticipated inflation and the FRB's monetary policy that follows.

Why Gold Fell (The Precious Metals Perspective)

Gold does not pay interest or dividends. Investors will rush into gold when they perceive heightened political risk and inflation risk. On the inflation risk side, two critical conditions that drive the price of gold are:

1. When investors fear a loss of FRB's credibility (currency debasement or runaway inflation).

2. When inflation-adjusted (real) interest rates fall to zero or negative, making holding cash less appealing than holding physical metal.

The available evidence suggests that neither condition was broadly present. Median inflation metrics showed that long-term inflation fears remained firmly bounded, and monetary growth was moderating. More importantly, because markets trusted the FRB to keep policy tight enough to fight inflation, real (inflation-adjusted) yields on government bonds remained attractive. With safe government bonds offering relatively solid real returns, the opportunity cost of holding zero-yield gold went up, putting downward pressure on gold prices.

Summary: Two Sides of the Same Credible Coin

Market Signal	What Happened	What It Tells Us About the FRB
Long-Term Treasury Yields	Rose	Markets are pricing-in anticipated cyclical growth and inflation.
Gold Prices	Softened	Markets trust that inflation will remain anchored, keeping real returns on bonds positive.
Monetary Base	Slower Growth	The FRB is maintaining balance-sheet discipline.

In summary, rather than conflicting, these two market behaviors are complementary pieces of evidence that investors continue to view the FRB as credible because:

·        The rise in bond yields showed that the market was pricing-in anticipated economic realities.

·    The weakness in gold prices suggests that investors generally continued to view the FRB as committed to maintaining price stability.

Conclusion:

When financial indicators seem to send mixed messages, it often pays to look beneath the surface. Inflation expectations can remain well anchored and not support the characterization that inflation fears have "roared back." The distinction is important. Markets may be pricing a somewhat higher inflation outlook than they were a few months ago, but that is very different from pricing an inflationary crisis.

Both trends point to one overarching reality today: the FRB’s policy credibility remains firmly intact.

Now, that reality can change. All we have to do is go back to the Great Financial Crisis of 2008 – 2010 to observe how reality changed quickly and suddenly.