Investigating the relationship between inflation and its effect on medium-to long-term bond yields: a Kenyan case study

Abstract

This study examines the determinants of government bond yields in Kenya, with a particular focus on bond tenor, inflation, and key macroeconomic variables such as the Central Bank Rate (CBR), GDP growth, and changes in money supply (M3). Using Ordinary Least Squares (OLS) regression and Instrumental Variables (IV) analysis on a dataset spanning 2013 to 2023, the study finds that inflation and the CBR significantly impact bond yields. A higher CBR leads to increased bond yields, reinforcing the Expectations Hypothesis, while inflation also exerts upward pressure on yields, in line with the Fisher Effect. Bond tenor plays a crucial role in yield determination, with longer term bonds generally offering higher yields due to increased risk premiums, as suggested by the Liquidity Preference Theory. However, GDP growth exhibits a weak negative relationship with bond yields, suggesting that economic expansion enhances investor confidence and reduces required risk premiums. The findings highlight the importance of monetary policy in managing yield dynamics and emphasize the need for stable inflation targeting to foster an attractive bond market.