Most investors care about future interest rates, none more so than bondholders. If you own a bond or a bond fund, consider whether Treasury yields and interest rates are likely to rise in the future, and to what extent. If rates are headed higher, you probably want to avoid bonds with longer-term maturities, shorten the average duration of your bond holdings, or plan to weather the ensuing price decline by holding your bonds to maturity to recoup par value and collect coupon payments in the meantime.
Key Takeaways
- To attract investors, any bond riskier than a Treasury bond with the same maturity must offer a higher yield.
- The Treasury yield curve shows the yields for Treasury securities of different maturities.
- A normal yield curve slopes upward with a concave slope, as the borrowing period, or bond maturity, extends into the future.
- The Treasury yield curve reflects the cost of U.S. government debt and is therefore ultimately a supply-demand phenomenon.
- Supply-related factors such as central bank purchases and fiscal policy, and demand-related factors, such as the fed funds rate, the trade deficit, regulatory policies, and inflation all shift the yield curve.
The Treasury Yield Curve
U.S. Treasury debt is the benchmark used to price other domestic debt and is an influential factor in setting consumer interest rates. Yields on corporate, mortgage, and municipal bonds rise and fall with those of the Treasuries, which are debt securities issued by the U.S. government.
To attract investors, any bond riskier than a Treasury bond with the same maturity must offer a higher yield. For example, the 30-year mortgage rate historically runs about one to two percentage points above the yield on 30-year Treasury bonds.
The Treasury yield curve (or term structure) shows the yields for Treasury securities of different maturities. It reflects market expectations of future interest rate fluctuations over varying periods of time.
Below is an example of the Treasury yield curve. This yield curve shape is considered normal because it slopes upward with a concave slope, as the borrowing period, or bond maturity, extends into the future.
:max_bytes(150000):strip_icc()/Clipboard01-f94f4011fb31474abff28b8c773cfe69.jpg "Understanding Treasury Yields and Interest Rates (1)")
Consider three properties of this curve. First, it shows nominal interest rates. Inflationwill erode the value of future coupon and principal repayments; the real interest rate is the return after deducting inflation. So the curve reflects the market's inflation expectations, among other factors
Second, the Federal Reserve directly controls only the short-term interest rate at the extreme left of the curve. It sets a narrow range for the federal funds rate, the overnight rate at which banks lend each other reserves.
Third, the rest of the curve is determined by supply and demand in an auction process.
Like all markets, bond markets match supply with demand; in the case of the market for Treasury debt, much of the demand comes from sophisticated institutional buyers. Because these buyers have informed opinions about the future path of inflation and interest rates, the yield curve offers a glimpse of those expectations in the aggregate.
If that sounds plausible, you also have to assume that only unanticipated events (for example, an unanticipated increase in inflation) will shift the yield curve up or down.
Long Rates Tend to Follow Short Rates
The Treasury yield curve can change in various ways.
- It can move up or down (a parallel shift)
- Become flatter or steeper (a shift in slope)
- Become more or less humped in the middle (a change in curvature)
The following chart compares the 10-year Treasury note yield (red line) to the two-year Treasury note yield (purple line) from 1977 to 2016. The spread between the two rates, the 10-year minus the two-year, (blue line) is a simple measure of steepness.
:max_bytes(150000):strip_icc()/treasury_yield_spreads_1-5bfd93ba46e0fb002643029d "Understanding Treasury Yields and Interest Rates (2)")
We can make two observations here. First, the two rates move up and down somewhat together (the correlation for the period above is about 88%). Therefore, parallel shifts are common. Second, although long rates directionally follow short rates, they tend to lag in the magnitude of the move.
Notably, when short rates rise, the spread between 10-year and two-year yields tends to narrow (the curve of the spread flattens) and when short rates fall, the spread widens (the curve becomes steeper). In particular, the increase 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 created a steeper curve in the spread, and; the marked drop in rates from 2000 to the end of 2003 produced an equally steep curve by historical standards.
Supply-Demand Phenomenon
So what moves the yield curve up or down? Well, let's admit we can't do justice to the complex dynamics of capital flows that interact to produce market interest rates. But we can keep in mind that the Treasury yield curve reflects the cost of U.S. government debt and is therefore ultimately a supply-demand phenomenon.
Supply-Related Factors
Central Bank Purchases: The Federal Reserve has purchased Treasury debt to ease financial conditions during downturns in a policy known as large-scale asset purchases or quantitative easing (QE), and can conversely sell government debt on its balance sheet during recovery in a quantitative tightening. Because large-scale asset purchases (and sales) of securities by a central bank can force other market participants to change their expectations, they can have a counterintuitive effect on bond yields.
Fiscal Policy: When the U.S. government runs a budget deficit, it borrows money by issuing Treasury debt. The more the government spends keeping revenue constant, the higher the supply of Treasury securities. At some point, as the borrowing increases, the U.S. government must increase the interest rate to induce further lending, all other things being equal.
Demand-Related Factors
Federal Funds Rate: If the Fed increases the federal funds rate, it is effectively increasing rates across the spectrum, since it is effectively the lowest available lending rate. Because longer-term rates tend to move in the same direction as short-term ones, fed fund rate changes also influence the demand for longer-dated maturities and their market yields.
U.S. Trade Deficit: Large U.S. trade deficits lead to the accumulation of more than $1 trillion annually in the accounts of foreign exporters, and ultimately foreign central banks. U.S. Treasuries are the largest and most liquid market in which such export proceeds can be invested with minimal credit risk.
Regulatory Policies: The adoption by bank regulators of higher capital adequacy ratios requiring increased holdings of high-quality liquid assets increased the attraction of Treasury notes for banks.
4.31%
The 10-year yield as of Mar. 15, 2024; up from 3.95% on Jan. 2, 2024.
Vast public and private pension plans and insurance company portfolios must also satisfy risk regulators while threading the needle between delivering the required returns and limiting the volatility of those returns. They are another source of demand for Treasuries.
Inflation: If we assume that buyers of U.S. debt expect a given real return, then an increase in expected inflation will increase the nominal interest rate (nominal yield = real yield + inflation). Inflation also explains why short-term rates move more rapidly than long-term rates: When the Fed raises short-term rates, long-term rates increase to reflect the expectation of higher future short-term rates. However, this increase is restrained by reduced inflation expectations because higher short-term rates also imply lower future inflation as they curb lending and growth:
:max_bytes(150000):strip_icc()/UnderstandingTreasuryYieldAndInterestRates2-81d89039418c4d7cae30984087af4aff.png "Understanding Treasury Yields and Interest Rates (3)")
An increase in fed funds (short-term) tends to flatten the curve because the yield curve reflects nominal interest rates: higher nominal = higher real interest rate + lower inflation.
Fundamental Economics
A stronger U.S. economy tends to make corporate (private) debt more attractive than government debt, decreasing demand for U.S. debt and raising rates. A weaker economy, on the other hand, promotes a "flight to quality," increasing the demand for Treasuries, which leads to lower yields.
It is sometimes assumed that a strong economy will automatically prompt the Fed to raise short-term rates, but not necessarily. The Fed is only likely to raise rates if growth spurs unwelcome inflation.
What Determines Treasury Yields?
Treasury yields are determined by interest rates, inflation, and economic growth, factors which also influence each other as well. When inflation exists, treasury yields become higher as fixed-income products are not as in demand. Strong economic growth also leads to higher treasury yields.
What Happens When Treasury Yields Go Up?
When yields rise, this signals a drop in the demand for Treasuries because investors are bullish about the economy and seek higher returns elsewhere. These investors believe there is a reduced need to invest in safer investments, such as Treasuries.
Why Do Treasury Yields Rise With Inflation?
Treasury yields rise with inflation in order to make up for the loss in purchasing power. Interest rates and bond yields both increase and prices decrease when inflation exists.
The Bottom Line
Longer-term Treasury bond yields move in the direction of short-term rates, but the spread between them tends to shrink as rates rise because longer-term bonds are more sensitive to expectations of a future slowing in growth and inflation brought about by the higher short-term rates. Bond investors can minimize the effect of rising rates by reducing the duration of their fixed-income investments.
