How US Treasury Yields Affect the Economy
Why Treasury Yields Fall When Demand Rises
Treasury yields are the total amount of money you earn by owning U.S. Treasury bills, notes, or bonds. The U.S. Treasury Department sells them to pay for the U.S. debt. It's crucial to remember that yields go down when there is a lot of demand for the bonds. Yields move in the opposite direction of bond values.
How Treasury Yields Work
Treasury yield prices are based on supply and demand. In the beginning, the bonds are sold at auction by the Treasury Department. It sets a fixed face value and interest rate.
If there is a lot of demand, the bond will go to the highest bidder at a price above the face value. This lowers the yield. The government will only pay back the face value plus the stated interest rate. Demand will rise when there is an economic crisis. This is because investors consider U.S. Treasurys to be an ultra-safe form of investment.
If there is less demand, then bidders will pay less than the face value. It then increases the yield.
Yield prices change every day because few investors keep them for the full term. Instead, they resell Treasuries on the secondary market. So, if you hear that bond prices have dropped, then you know that there is not a lot of demand for the bonds. Yields must increase to compensate for lower demand.
How They Affect the Economy
As Treasury yields rise, so do the interest rates on consumer and business loans with similar lengths. Investors like the safety and fixed returns of bonds. Treasurys are the safest since they are guaranteed by the U.S. government. Other bonds are riskier. They must return higher yields in order to attract investors. To remain competitive, interest rates on other bonds and loans increase as Treasury yields rise.
When yields rise on the secondary market, the government must pay a higher interest rate to attract buyers in future auctions. Over time, these higher rates increase the demand for Treasurys. That's how higher yields can increase the value of the dollar.
How They Affect You
The most direct manner in which Treasury yields affect you is their impact on fixed-rate mortgages. As yields rise, banks and other lenders realize that they can charge more interest for mortgages of similar duration. The 10-year Treasury yield affects 15-year mortgages, while the 30-year yield impacts 30-year mortgages. Higher interest rates make housing less affordable and depress the housing market. It means you have to buy a smaller, less expensive home. That can slow gross domestic product growth.
Did you know that you can use yields to predict the future? It’s possible if you know about the yield curve. The longer the time frame on a Treasury, the higher the yield. Investors require a higher return for keeping their money tied up for a longer period of time. The higher the yield for a 10-year note or 30-year bond, the more optimistic traders are about the economy. This is a normal yield curve.
If the yields on long-term bonds are low compared to short-term notes, then investors are uncertain about the economy. They would be willing to leave their money tied up just to keep it safe. When long-term yields drop below short-term yields, you’ll have an inverted yield curve. It predicts a recession.
One way to quantify this is with the Treasury yield spread. For example, the spread between the 2-year note and the 10-year note tells you how much more yield investors require to invest in the longer-term bond. The smaller the spread, the flatter the curve.
Recent Yield Trends
The yield curve reached a post-recession peak on January 31, 2011. The 2-year note yield was 0.58. That's 2.84 basis points lower than the 10-year note yield of 3.42.
This is an upward-sloping yield curve. It revealed that investors wanted a higher return for the 10-year note than for the 2-year note. Investors were optimistic about the economy. They wanted to keep spare cash in short-term bills, instead of tying up their money for 10 years.
The yield curve has flattened since then. For example, the spread fell to 1.21 on July 25, 2012. The yield on the 2-year note was 0.22, while the yield on the 10-year was 1.43. Investors had become less optimistic about long-term growth. They didn't require as much of a yield to tie up their money for longer.
On December 3, 2018, the Treasury yield curve inverted for the first time since the recession. The yield on the five-year note was 2.83. That's slightly lower than the yield of 2.84 on the three-year note. In this case, you want to look at the spread between the 3-year and 5-year notes. It was -0.01 points.
|Date||3-Mo||2-Yr||3-Yr||5-Yr||10-Yr||3-5 yr. Spread|
|Dec. 3, 2018||2.38||2.83||2.84||2.83||2.98||-0.01|
Bloomberg discussed a yield curve spread that investors believed the economy would be a bit better in five years than in three years. They based this on actions by the Federal Open Market Committee. Investors worried it could have triggered a slowdown in three years if the Fed raised rates too high. They believed the economy would have recovered in five years. As a result, they would have preferred to hold Treasurys for five years rather than three. That portion of the yield curve improved after the Federal Open Market Committee signaled it has finished raising the fed funds rate.
It had been planning to raise it to 3.0 percent by the end of 2020.
On March 22, 2019, the Treasury yield curve inverted more. The yield on the 10-year note fell to 2.44. That's 0.02 points below the three-month bill. The Federal Reserve Bank of Cleveland found that the spread between these two indicators is one of the best indicators of future recessions. It reliable predicted a recession would occur about a year out.
Does that mean we will definitely have a recession in March 2020? No. The Fed only said there's around a 25% chance of a recession. In fact, there were two times the curve inverted and a recession didn't occur at all. But it does bear continued watching to see if this relationship further inverts.
The chart below illustrates yield curves starting in 2005 up until 2019, showing that inverted yield curves can predict a recession.
Rates began rising in 2017 and will continue to do so in 2019. The Fed started raising the fed funds rate beginning in December 2015. As investors receive more yield for short-term bills, they'll expect a better return for longer-term notes. But if they lose confidence in the economy, they will buy long-term bonds regardless of the yield on short-term bills. That will further flatten the yield curve.
In the medium-term, there are ongoing pressures to keep yields low. Economic uncertainty in the European Union keeps investors buying traditionally safe U.S. Treasurys. Foreign investors, China, Japan, and oil-producing countries, in particular, need U.S. dollars to keep their economies functioning. The best way to collect dollars is by purchasing Treasury products. The popularity of U.S. Treasurys has kept yields below 6 percent since 2011.
In the long-term, four factors put upward pressure on Treasury yields:
- The huge U.S. debt worries foreign investors, who wonder if the United States will ever repay them. It is the main concern for China, the largest foreign holder of U.S. Treasurys. China often threatens to purchase fewer Treasurys, even at higher interest rates. If this happens, it would indicate a loss of confidence in the strength of the U.S. economy. It would drive down the value of the dollar in the end.
- One way the United States can reduce its debt is by letting the value of the dollar decline. When foreign governments demand repayment of the face value of the bonds, it will be worth less in their own currency if the dollar's value is lower.
- The factors that motivated China, Japan, and oil-producing countries to buy Treasury bonds are changing. As their economies become stronger, they are using their current account surpluses to invest in their own country's infrastructure. They aren't as reliant upon the safety of U.S. Treasurys and are starting to diversify away.
- Part of the attraction of U.S. Treasurys is that they are denominated in dollars, which is a global currency. Most oil contracts are denominated in dollars. Most global financial transactions are done in dollars. As other currencies, such as the euro, become more popular, fewer transactions will be done with the dollar. This will end up lessening its value and that of U.S. Treasurys.
The Taper Tantrum
In 2013, yields rose 75 percent between May and August alone. Investors sold off Treasurys when the Federal Reserve announced that it would taper its quantitative easing policy. In December of that year, it began reducing its $85 billion a month purchases of Treasurys and mortgage-backed securities. The Fed cut back as the global economy improved.
The Yield Hit 200-Year Lows in 2012
According to Reuters, on June 1, 2012, the benchmark 10-year note yield hit an intra-day low of 1.442 percent, the lowest since the early 1800s. It closed a little bit higher, at 1.47 percent. It was caused by a flight to safety as investors moved their money out of Europe and the stock market.
Yields fell further, reaching a new record low on July 25. The yield on the 10-year note closed at 1.43 percent. Yields were abnormally low due to continued economic uncertainty. Investors accepted these low returns just to keep their money safe. They were concerned about the eurozone debt crisis, the fiscal cliff, and the outcome of the 2012 presidential election.
Treasury Yields Predicted the 2008 Financial Crisis
In January 2006, the yield curve started to flatten. It meant that investors did not require a higher yield for longer-term notes. On January 3, 2006, the yield on the one-year note was 4.38 percent, a bit higher than the yield of 4.37 percent on the 10-year note. This was the dreaded inverted yield curve. It predicted the 2008 recession. In April 2000, an inverted yield curve also predicted the 2001 recession. When investors believe the economy is slumping, they would rather keep the longer 10-year note than buy and sell the shorter one-year note, which may do worse the following year when the note is due.
Most people ignored the inverted yield curve because the yields on the long-term notes were still low. It was less than 5 percent. This meant that mortgage interest rates were still historically low and indicating plenty of liquidity in the economy to finance housing, investment, and new businesses. Short-term rates were higher, thanks to Federal Reserve rate hikes. This impacted adjustable rate mortgages the most. Long-term Treasury note yields stayed at around 4.5 percent, keeping fixed-rate mortgage interest rates stable at around 6.5 percent.