Treasury Yields and Interest Rates: What You Need to Know

Treasury Yields and Interest Rates: What You Need to Know

Bondholders, more than any other type of investor, are concerned about future interest rates. If you’re thinking about buying a bond or a bond fund, you should examine whether you think Treasury yields and interest rates will climb in the future. If you answered yes, you should either avoid long-term maturity bonds or reduce the average duration of your bond holdings, or plan to ride out the price drop by holding your bonds until they expire and collecting the par value.

The Treasury yield curve (or term structure) is the first mover of all domestic interest rates and a key element in establishing global rates in the United States. Treasuries, which are debt instruments issued by the United States government, drive interest rates on all other domestic bond categories up and down. Any bond or debt security with a higher risk than a comparable Treasury bond must offer a higher yield to attract investors. The 30-year mortgage rate, for example, has generally been 1% to 2% higher than the yield on 30-year Treasury bonds.

 

The real Treasury yield curve as of January 21, 2021 is depicted in the graph below. Because it slopes upward with a concave slope as the borrowing period, or bond maturity, continues into the future, it is considered typical in shape:

 

Take a look at three different aspects of this curve. It starts with nominal interest rates. Inflation will depreciate the value of future coupon dollars and principal repayments; the real interest rate is the return after inflation has been deducted. As a result, the curve incorporates both expected inflation and real interest rates.

 

Second, only the short-term interest rate at the beginning of the curve is actively manipulated by the Federal Reserve. The Fed has three policy tools, but the federal funds rate, which is only a one-day, overnight rate, is the most powerful. 3 Third, supply and demand in an auction process decide the rest of the curve.

 

The yield requirements of sophisticated institutional purchasers, as well as their appetite for government bonds, dictate how they bid. Many of these buyers perceive the yield curve to be a crystal ball that already delivers the best available prediction of future interest rates since they have informed opinions on inflation and interest rates. If you believe that, you also believe that the yield curve will only be shifted up or down by unanticipated events (for example, an unanticipated spike in inflation).

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Short rates tend to be followed by long rates.

The Treasury yield curve can alter in a variety of ways, including moving up or down (a parallel shift), becoming flatter or steeper (a slope shift), or becoming more or less humped in the middle (a change in curvature).

 

From 1977 to 2016, the 10-year Treasury note yield (red line) was compared to the two-year Treasury note yield (purple line). The difference between the 10-year and two-year rates (blue line) is a basic measure of steepness:

 

We can draw two conclusions from this. First, the two rates rise and fall in lockstep (the correlation for the period above is about 88 percent ). As a result, parallel shifts are quite common. Second, whereas long rates tend to follow short rates in direction, they lag in size.

 

When short rates rise, the spread between 10-year and two-year yields narrows (the curve of the spread flattens), and when short rates fall, the spread widens (the curve of the spread widens) (curve becomes steeper). The rise in rates from 1977 to 1981 was accompanied by a flattening and inversion of the curve (negative spread); the drop in rates from 1990 to 1993 resulted in a steeper curve in the spread; and the sharp drop in rates from 2000 to the end of 2003 resulted in an equally steep curve by historical standards.

 

Phenomenon of Supply and Demand

So, what causes the yield curve to rise or fall? Let’s face it: we can’t possibly do justice to the intricate dynamics of capital flows that interplay to determine market interest rates. However, we must remember that the Treasury yield curve reflects the cost of US government debt and is thus a supply-demand issue.

 

Factors Affecting Supply

Policy on Money and Credit

If the Fed wishes to raise the fed funds rate, it will use open market operations to supply additional short-term securities. Because borrowers give money to the Fed, the growth in the supply of short-term securities restricts the amount of money in circulation. As a result of the decline in the money supply, the short-term interest rate rises since borrowers have less money in circulation (credit). The Fed is tugging up the very left end of the curve by expanding the supply of short-term assets, and the nearby short-term yields will snap in lockstep.

 

Is it possible to forecast future short-term rates? According to the expectations theory, long-term rates contain a forecast of future short-term rates. However, when we look at the real yield curves that have been observed in the markets over time, the pure form of this hypothesis has not fared well: During a normal (upward-sloping) yield curve, interest rates are frequently flat.

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The most likely explanation is that the two-year bond contains additional yield since a longer bond needs you to bear greater interest-rate volatility. When we look at the yield curve from this perspective, we can see that the two-year yield has two components: a prediction of the future short-term rate and additional yield (i.e., a risk premium) to compensate for the uncertainty. So, whereas a steeply sloping yield curve indicates an increase in the short-term rate, a gently upward-sloping curve indicates no change in the short-term rate—the upward slope is attributable mainly to the additional return awarded for the risk associated with longer-term bonds.

 

Because Fed-watching is a professional sport, waiting for a move in the fed funds rate isn’t enough; only surprises matter. As a bond investor, it’s critical to strive to keep one step ahead of the rate, anticipating rather than reacting to fluctuations. Market participants all across the world study the phrasing of each Fed statement (as well as the speeches of Fed governors) in an attempt to deduce future intentions.

 

Budgetary Policy

When the US government runs a deficit, it borrows money from institutional lenders by issuing longer-term Treasury bonds. The more money the government borrows, the more debt it will issue. As borrowing grows, the US government will eventually have to raise interest rates to encourage more lending. 4

 

Foreign lenders, on the other hand, will always be happy to hold Treasury bonds because they are highly liquid and the United States has never defaulted on a large scale (it came close in late 1995, but Robert Rubin, the Treasury Secretary at the time, averted the threat and has described a Treasury default as “unthinkable—something akin to nuclear war”).

Foreign lenders, on the other hand, can readily turn to alternatives such as Eurobonds and, as a result, can demand a higher interest rate if the US tries to supply too much debt.

 

Factors Affecting Demand

Inflation

If we assume that borrowers of US debt expect a certain real return, rising inflation will raise the nominal interest rate (nominal yield = real yield + inflation). Short-term rates rise more quickly than long-term rates due to inflation: When the Fed raises short-term rates, long-term rates rise to reflect the expectation of higher future short-term rates; however, this rise is offset by lower inflation expectations, as higher short-term rates imply lower inflation (the Fed collects money and tightens the money supply as it sells/supplies more short-term Treasuries):

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Because the yield curve represents nominal interest rates: higher nominal = higher real interest rate + lower inflation, an increase in fed funds (short-term) tends to flatten the curve.

 

Economic Fundamentals

Economic development, competing currencies, and hedging options are all reasons that drive demand for Treasuries. Remember that anything that increases demand for long-term Treasury bonds tends to lower interest rates (higher demand = higher price = lower yield or interest rates), while anything that decreases demand for bonds tends to raise interest rates (lower demand = higher price = higher yield or interest rates).

 

A stronger US economy makes business (private) debt more appealing than government debt, resulting in lower demand for US debt and higher rates. A weaker economy, on the other hand, encourages a “flight to quality,” resulting in increased demand for Treasuries and lower yields. A healthy economy is commonly considered to automatically inspire the Fed to raise short-term rates, but this is not always the case. The Fed is only likely to hike rates if and when growth translates or overheats into higher prices.

 

Treasury bonds compete with the debt of other countries in the global economy. Treasuries are an investment in both US real interest rates and the USD on a global scale. The euro is a very important option: For the most of 2003, the European Central Bank kept its short-term rate at 2%, which was higher than the fed funds rate of roughly 1%. 6 & 7

 

Finally, Treasuries play a significant role in market participants’ hedging actions. Many investors of mortgage-backed securities, for example, have been hedging their prepayment risk by acquiring long-term Treasuries in low-interest settings. 8 These hedging purchases can help keep rates low by increasing demand, but there is fear that they may also contribute to instability.

 

Final Thoughts

We’ve gone over some of the most important traditional elements that influence interest rate changes. Monetary policy determines how much government debt and money are put into the economy on the supply side. Inflation expectations are the most important influence in demand.

 

Other key impacts on interest rates, such as fiscal policy (that is, how much does the government need to borrow?) and other demand-related factors like economic growth and competitive currencies, have also been examined.

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