10-Year Treasury Note - How It Works

Why It's the Most Important

The 10-Year Treasury yield guides the 15-year mortgages rate.. By: Joe Raedle/Getty Images

The 10-year Treasury note is a loan you make to the U.S. government. It is one of the U.S. Treasury bills, notes and bonds, and it's the only one that matures in a decade.

The 10-year Treasury note rate is the yield, or rate of return, you get for investing in this note. The yield is important because it is the benchmark that guides almost all other interest rates. The exception is adjustable rate mortgages, which follow the Fed funds rate.

But even the Federal Reserve watches the 10-year Treasury yield before making its decision to change the Fed funds rate. That's because the 10-year Treasury note, like all other Treasuries, is sold at an auction. Therefore, the yield indicates the confidence that investors have in economic growth.

The 10-Year Treasury Note

The U.S. Treasury Department auctions the 10-year Treasury note. The note is the most popular debt instrument in the world. That's because it's backed by the guarantee of the U.S. economy. Compared to most other countries' sovereign debt, there is little risk of a U.S. debt default.

That's true even though the current U.S. debt is more than 100% debt to GDP ratio. That means that it would take the entire production of the American economy a year to pay off its debt. Investors normally get worried about a country's ability to pay when the ratio is more than 77%. It's not a problem when it only lasts for a year or two, but can depress growth if it lasts for decades.

 (Source: World Bank, Finding the Tipping Point)

Since the United States can always print more dollars, there's virtually no reason it even needs to default. The only way it could is if Congress didn't raise the debt ceiling. That would forbid the U.S. Treasury from issuing new Treasury notes. 

How Do Treasury Rates Work?

A low rate on the 10-year Treasury note means there is a lot of demand for it.

That seems counterintuitive. Wouldn't people prefer a note with a high rate? However, Treasuries are initially sold at auction by the Treasury Department, which sets a fixed face value and interest rate. It's easy to confuse the fixed interest rate with the yield on the Treasury. It's even easier because most people refer to the yield as the Treasury rate. When people say "the 10-year Treasury rate," they don't mean the fixed interest rate paid throughout the life of the note. They mean the yield.

Treasury products are sold to the highest bidder at either the initial auction or on the secondary market. When there is a lot of demand, investors bid at or above the face value. In that case, the yield is low because they will get a lower return on their investment. It's worth it to them, though, because they know their investment is safe. They are willing to accept a low yield in return for lower risk. That's why you'll see Treasury rates fall during the recession phase of the business cycle.

That's what you want to see because it will drive bank lending rates, and all other interest rates, down. It provides greater liquidity right when the economy needs it.

When there's a bull market or the economy is in the expansion phase of the business cycle, there are plenty of other investments. Investors are looking for more return than a 10-year Treasury note will give. Therefore, there's not a lot of demand. Bidders are only willing to pay less than the face value. In that case, the yield is higher. Treasuries are sold at a discount, so there is a greater return on the investment. In short, Treasury rates always move in the opposite direction of Treasury bond prices.

Treasury yields change every day. That's because they are resold on the secondary market. Hardly anyone keeps them for the full term. If bond prices drop, it means so has demand for Treasuries. That drives yields up as investors require more return for their investments.

How the 10-Year Treasury Note Affects You

As yields on the 10-year Treasury note rises, so do the interest rates on 10-15 year loans, such as the 15-year fixed-rate mortgages. That's because investors who buy bonds are looking for the best rate with the lowest return. If the rate on the Treasury note drops, then the rates on other, less safe investments can also fall and remain competitive. However, their rates will always be a bit higher than Treasuries. They must compensate investors for their higher risk of default. Second, even if 10-year Treasury note yields dropped lower, mortgage interest rates probably won't fall much lower. Lenders have processing costs they've got to cover even if Treasury yields fall to zero.

How does this affect you? Well, it makes it cost less to buy a home because now you've got to pay the bank less interest to borrow the same amount. As home buying becomes less expensive, demand should rise. As the real estate market strengthens, it has a positive effect on the economy, increasing GDP growth

Why the 10-Year Treasury Hit Record Lows

Usually, the longer the time frame on a Treasury product, the higher the yield. Investors require a higher return for keeping their money tied up for a longer period. That's called the yield curve.

On June 1, 2012, the 10-year Treasury rate hit an intra-day low of 1.442 percent, the lowest rate since the early 1800s. Investors worried about the eurozone debt crisis and a poor jobs report. They responded by putting their money into the traditional haven, the 10-year Treasury. On July 25, 10-year note yield closed at 1.43, setting a new record. 

On July 1, 2016, the yield on the 10-year Treasury set another new record. It hit an intra-day low of 1.385%, beating the prior intra-day low of 1.389% set on July 24, 2012. It closed at 1.46%. Investors were concerned about Great Britain's vote to leave the European Union. (Source: "U.S. Treasury Yields Plunge as Investors Expect Central Banks to Support Growth," WSJ, July 1, 2016.)

Investors have yet to recover their confidence lost during the 2008 financial crisis. As a result, the 10-year note yield is lower than it was in 2008. (Source: Reuters, "Weak jobs data knock U.S. yields lower," June 1, 2012)

The 10-Year Note and the Treasury Yield Curve

You can learn a lot about where the economy is in the business cycle by looking at the Treasury yield curve. The curve is a comparison of yields on everything from the short-term Treasury bill to the longest-term Treasury bond. The 10-year note is somewhere in the middle, so it gives an indication of how much return investors need to tie up their money for ten years. If they think the economy will do better in the next decade, they will require a higher yield to keep their money socked away. When there is a lot of uncertainty, they don't need much to keep their money safe.

Usually, investors don't need much return to keep their money tied up for only short periods of time, and they need a lot more to keep it tied up for longer. For example, on July 1, 2016, the yield curve was:

  • 0.37% on the 3-month Treasury bill,
  • 0.45% on the 1-year Treasury note,
  • 1.46% on the 10-year Treasury note,
  • 2.24% on the 30-year Treasury bond.

That's a flat yield curve. Investors only required 1.87 percentage points more to keep their money tied up for 30 years vs. three months. That means they don't think the economy will grow a whole lot more in the future than it's growing now. It could also mean some investors think things will get a lot better while others disagree.

On the other hand, when investors demand more return in the short term than in the long run, that's known as an inverted yield curve. That means they think the economy is headed for a recession. (Source: U.S. Treasury Department, Daily Treasury Yield Curve Rate

Continue Reading...