While inflation has surged to levels not seen in more than three decades, the government bond market seems to be buying the Federal Reserve's argument that inflation will not stick around.

Since April, the Consumer Price Index, the market's preferred inflation metric, has seen an average year-over-year increase of 5.3%. In October, the index jumped 6.2%, the highest year-over-year increase since November 1990.

Federal Reserve Chairman Jerome Powell has argued for months that the rise in inflation is transitory, caused by spikes off historic lows during the pandemic and ongoing supply chain challenges amid rising demand. The bond market has, so far, agreed, with long-dated bonds not running up alongside inflation. Yields in shorter-duration Treasurys increased while longer-dated bond yields dropped. For banks, an increase in short-term rates should provide a boost to net interest income by lifting yields on their many assets that are priced using variable rates.

"The bond market is surprisingly sanguine of higher inflation," said Antoine Bouvet, a senior rates strategist with ING.

From April through Nov. 12, the one-year Treasury bill climbed 11 basis points to 0.17%, and the five-year note gained 34 basis points to 1.24%. Meanwhile, longer-dated bond yields declined over that time: the 10-year yield fell 11 basis points to 1.58%, and the 30-year yield dropped 39 basis points to 1.95%.

Bond yields move inversely to prices, with a rising yield signifying declining demand for bonds. Yields tend to rise during periods of high growth and inflation, but the decline in long-dated bonds suggests the market anticipates inflation will be short-lived.

Inflation remains a key driver of bond yields, but its direction and duration remains a source of fierce debate among investors, said Kathy Jones, managing director and chief fixed-income strategist for the Schwab Center for Financial Research.

"The problem is that market participants are split about how high it is going and how long it will last," Jones said.

The Fed has begun to taper its $120 billion in monthly securities purchases and plans to end the program by June. While Powell has stressed that the end of the taper will not be tied with a rate hike, the majority of market participants expect a rate hike to follow the Federal Open Market Committee's June meeting.

Market odds for at least one rate hike by June 2022 were at nearly 69% on Nov. 12, up from about 44% a month earlier, according to the CME FedWatch Tool, which measures investor sentiment in the Fed funds futures market.

Market odds for at least two rate hikes by the FOMC's November 2022 meeting were at about 65% as of Nov. 12, up from 39% a month earlier, according to the tool.

These expected hikes are keeping longer bond yields down. With short-dated bonds increasing, the yield curve — a representation of the difference between short-dated bonds and long-dated ones — has flattened.

"The market thinks the Fed will be able to tame inflation via their policy, hence the yield curve flattening," said John Luke Tyner, a fixed income analyst at Aptus Capital Advisors. "The market thinks the Fed can slowly taper and possibly gently raise rates without screwing anything up."

Banking boon

The prospect for faster hikes by the Fed reinforced optimism that the rate environment could get better for the banking industry. The S&P U.S. BMI Banks Index ticked up 0.15% on the day of the inflation report, compared with a 0.82% decline for the S&P 500.

Long-term yields remain stuck below levels that many banks are looking for in their securities portfolios , but a rise in short-term rates would relieve pressure on net interest margins that have been crushed. Prior to the recent runup, low short-term rates depressed banks' assets — including those with variable rates — while banks were unable to lower deposit costs that were already near zero.

Banks have enormous pools of low-cost deposits with large revenue upsides in higher rate environments. Bank of America Corp. reports a model on how rate movements would affect the bank's net interest income over the next 12 months. Assuming an instantaneous, 100-basis-point increase in rates across the yield curve, the bank would realize a $7.16 billion boost over the coming year, with most of the impact coming from the short end. A flattener scenario, which includes a 100-basis-point increase in the short end and no change in the long end, would translate to a hypothetical increase of $4.93 billion.

"The bear-flattening of the yield curve is consistent with the expectations that the Fed will begin to hike interest rates. However, it only implies that the front part of the yield curve rises faster than long-term yields," said Althea Spinozzi, a senior fixed-income strategist with Saxo Bank. "Long-term yields will need to follow, but at a slower pace."

Noninterest deposits constitute 39.6% of Bank of America's deposit base, providing an opportunity for net interest income gains as rates rise. Since the cost of noninterest deposits changes little in a rising-rate environment, banks with significant noninterest deposits stand to benefit more from higher rates that will boost asset yields.

Easing inflation

Most economists believe that growth and inflation will ease at some point next year as supply and demand imbalance even out. The bond market seems to acknowledge this consensus, agreeing that the ongoing spike in inflation is largely transitory.

But Jones with Schwab said market participants are wrestling with where inflation will end up when this transitory period concludes.

"Does it revert back to pre-pandemic levels below 2%, or does it end up being closer to 3% due to ample fiscal stimulus, rising wages and declining globalization?" Jones said.