Credit: Shutterstock photoI have pointed out here in the past that while most retail traders and investors focus almost entirely on the stock market, the pros in dealing rooms around the world keep a wary eye on bonds, and in particular, U.S. Treasuries. Over the last couple of weeks, it has become clear why that is so.
The stock market dropped like a stone a couple of weeks ago, prompted by moves in the Treasury market, and continues to be led by bonds, as shown by Wednesday’s reversal and quick drop as the 10 Year yield approached the three percent mark. It would therefore seem like a good time for a basic discussion of the Treasury market, how it works, what drives it, and what it means to you, the investor.
The term “Treasuries” is used to refer collectively to debt securities issued by the U.S. Government. That debt can be short or long term, ranging from borrowing for a short time to what is known as the “long bond” which matures in thirty years. U.S. Government debt is considered by the world’s financial community to be an essentially risk-free asset, as the power to tax and add money to the world’s largest free market economy is seen as ensuring that when the bonds mature, the initial amount borrowed will be repaid.
The Treasury market is not usually talked about in terms of price, but rather yield, the annual effective interest rate that buyers will receive. That rate is used as a benchmark off which others, including your mortgage, car loan and credit card rates. That alone makes movement in Treasury yields significant, but there is a broader effect.
It also influences the rate at which businesses can borrow to invest in new plants or improvements and that is why the recent rise in yields has caused stocks to fall.
The direct cause of that rise was people and institutions selling Treasuries. With any fixed income product, the yield goes up as the price goes down, so to understand why yields have risen this time you must look at why people are selling bonds.
The answer is that it is in anticipation of higher interest rates to come. We know that the Fed is trying to “normalize” rates, which means that they will be taking various measures designed to raise them. If you know that at some point in the future the 10 Year Note will offer a return of say 3-3.5% it makes no sense to stay locked in at a 2.6% return for ten years. Logic dictates that you sell and look elsewhere.
That dynamic, however, has existed for a while, so why the sudden jump in rates since the start of the year? It comes from fears in the market that adding the stimulus of tax cuts and increased government spending to an economy that is this far into a sustained recovery will add inflationary pressure.
In other words, that could force the Fed to raise rates faster than they have planned to this point to avoid overheating.
That all makes sense, but at least in part the reason for the size and rapidity of the move up in yields from well under 2.5% to close to 3% that you can see in the above chart is technical. Technical factors matter more in the Treasury market than the stock market, and what started as an orderly and understandable climb given the Fed’s stated intentions gained pace when a key resistance level at around 2.62% was broken.
The current fear is that if we break above the psychologically important 3% level we will see the same again, pushing yields past the point suggested by economic conditions and creating a real problem for both business and personal borrowers.
You should keep in mind, however, that that has not yet happened. If it does it could change the outlook, but at around 3%, the yield on the 10 Year Note looks appropriate to current conditions and will not really act as a deterrent to investment. That is why stocks have rebounded, and we can expect them to continue higher if rates stabilize at around these levels.
If, however, 10 Year yields do break above 3% and stay there that could spark another major decline in stocks, and one that would be much less likely to bounce straight back. That is why, even if the bond market seems too complex, esoteric or boring to you, you should make sure that you at least understand it and pay attention to it. Hopefully, if you have read this far, you will now do both.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
