Business & Markets Taxes & Economics

The Significance of Treasury Yields

Treasury note yields are important economic indicators that are often overlooked during times of economic expansion. Treasury notes are important to the economy because, in contrast with equities, they have little risk – they are backed by the US economy. When investors believe economic contraction is on the horizon, they will be more interested in buying treasury notes that shield them from the potential of a stock market collapse, which drives up the demand for bonds and hence drives down their interest rate. In recent weeks, US Treasury and global government bond yields have been dropping significantly. This has been driving the equities market down and has raised concerns about a recession being on the horizon. Specifically, one can look to dropping treasury yields and an inverted yield curve as red flags in the economy, and as reasons for which global markets have been falling across the board in recent weeks.

When treasury yields decrease, it is indicative of an increase in demand for safe investments, stemming from investor’s concern about the economic outlook. In recent years, many government bonds in the global market have been offering negative yields, meaning that investors are willing to pay the government to keep their money. As Germany’s bond yields have turned negative, almost a quarter of global government bonds (over 15 trillion USD) now yield negative returns.

Graph via CNBC.

Negative yields can occur for two reasons. First off, if a central government is trying to stimulate the economy, it will likely lower interest rates. This occurs in two ways. First off, the government will lower its policy interest rate, which stimulates investment and will appreciate the domestic currency. Secondly, the government will buy government bonds to try and increase the money supply in the economy – this will also result in a decrease in interest rates. The other driver of negative interest rates is the supply and demand for bonds. When a market slowdown is expected, the demand for bonds increases, as they are a safe investment, and their interest rates are guaranteed. This increase in demand will increase the price one has to pay for the bond, hence lowering its yield. In recent weeks, the US 10 Year Treasury Note has seen dramatic decreases in yields. On July 31st, US 10 Year Treasury Notes yielded 2.02%, whereas, on August 14th, yields dropped to 1.60%. These extremely low yields underscore widespread concern over the direction of the economy. In fact, although not a nominally negative interest rate, a security yielding 1.60% is, in fact, returning a real loss, considering expected inflation rates. 

Low yields are a problem for many reasons. It is important to first understand that Treasury note yields are the major determinant of mortgages and loan rates throughout the economy. First off, this makes the bank industry unprofitable. In Scandinavia, where interest rates have been used to depreciate domestic currency values (specifically in Denmark), and are largely negative to prop up the economy, banks are forced to rely on fees to make a profit. Secondly, low-interest rates punish lenders and reward borrowers, which encourages people to avoid savings and increase spending. Although in the short run this will increase GDP and boost the economy, it also leaves the economy more vulnerable to higher interest rates in the future. Thirdly, low-interest rates leave central banks little room to apply monetary policy during an economic downturn. Although low-interest rates for years have helped boost one of the longest economic bull periods, lower Treasury Yields are a warning sign for the economy.

Another important indicator of the state of the economy is a concept called the yield curve. The yield curve demonstrates the difference between long term and short term yields on fixed-rate investments (bonds, mortgage rates, etc). During times of economic growth, the yield curve is bowed outwards, as investors demand higher rates to lock their money in for greater term. This is because investors expect interest rates to keep rising as the economy grows, and because stability is expected, investors get a premium to lock in there investments long term.

When the yield curve inverts, it is a very negative sign for the economy; the yield curve on 2 to 10 year US Treasury notes inverted within 18 months of the last seven recessions. When the yield curve inverts, it demonstrates that investors expect yields to decrease in the future, and they hence will pay less for long term rates that shield them from potential drops in future yields or from economic downturn. On August 14th, the US 2 and 10 year Treasury rates inverted by 1.5 basis points, due in part to poor economic results from Germany and China. This drove the Dow Jones Industrial Average down 800 points and adds momentum to bearish sentiments and fears of a recession in the near future.

Overall, because there are so many economic indicators, it is hard to distinguish which ones are important and what each indicator is telling investors. Government Bond Yields and Yield Curves are some of the most consistent, reliable forecasters of the direction of the economy, for the reasons highlighted above. Bond Yields illustrate investors’ sentiment towards the economy, and yield curves are one of, if not the most consistent warning sign of an incoming recession.

By Simon Hungate

I am a high school student in Toronto, Canada who is interested in following and monitoring global markets and economies.

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