Explain the impact of inflation expectations on fixed income pricing.

Higher expected inflation typically leads to lower bond prices because bond investors require a higher yield to compensate for the erosion of purchasing power that inflation causes. When inflation expectations rise, the real return on bonds—defined as the nominal interest rate minus inflation—decreases. Investors anticipate that the fixed interest payments they receive from bonds will be worth less in the future due to inflation, which results in a sell-off of existing bonds. This sell-off pushes bond prices down in the market, leading to a rise in yields as prices and yields have an inverse relationship.

In contrast, when inflation expectations are stable or lower, bond prices may remain steady or even increase as investors feel more secure about the purchasing power of their future cash flows. Therefore, the dynamics of inflation expectations significantly influence the fixed income market, primarily through their impact on investor behavior regarding required yields and the attractiveness of interest payments relative to inflation.