Treasury Yields: How They Work and Affect the Economy
Why Treasury Yields Fall When Demand Rises
Definition: Treasury yields are the total amount of money you earn by owning U.S. Treasury notes or bonds. They are sold by the U.S. Treasury Department to pay for the U.S. debt. The most important thing to realize is that yields go down when there is a lot of demand for the bonds. That's why yields move in the opposite direction of bond values.
How Does It Work?
Treasury yields are determined through supply and demand.
The bonds are, in the beginning, 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 almost anyone keeps them for the full term. Instead, they are resold on the open market. Therefore, 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 and therefore must return higher yields in order to attract investors. To remain competitive, interest rates on other bonds and loans increase as 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 makes housing less affordable, thereby depressing 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. Often, 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 often predicts a recession.
For example, here's the yield curve for December 31, 2014:
|Time to Maturity||Yield|
This is an upward-sloping yield curve. It shows that investors want a higher return for the 30-year bond than for the 3-month bill. Investors are optimistic about the economy. They would rather not tie up their money for 10 or 30 years. (Source: U.S. Treasury, Daily Treasury Yield Curve Rates)
The yield curve flattened in 2016. On July 1, 2016, it was:
|Time to Maturity||Yield|
This shows that investors had become less optimistic about long-term growth. They required a lower yield to tie up their money for longer.
Rates will go up in the end, either in 2017 or 2018. The Fed started raising the fed funds rate in December 2015. As investors receive more yield for short-term bills, they'll expect a better return for longer-term notes. For more, see When Will Interest Rates Go Up?
In the medium-term, there are ongoing pressures to keep yields pretty 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 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 for the last seven years. For more, see Three Ways to Measure the Value of the Dollar.
In the long-term, four factors will make Treasury products less popular over the next 20 years.
- The huge U.S. debt worries foreign investors, who wonder if the U.S. will ever repay them. It is a main concern for China, the largest foreign holder of U.S. Treasurys. China often threatens to purchase less 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 U.S. 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
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. (Source: "Weak Jobs Data Knock U.S. Yields Lower," Reuters, June 1, 2012.)
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. (Source: "Daily Treasury Yield Curve Rate," U.S. Treasury Department.)
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.