- The 10-year Treasury yield is the yield paid to buyers of 10-year Treasury Notes
- It is Wall Street’s most-followed benchmark for interest rates.
- Inflation, monetary policy, and investor confidence all drive the direction of the 10-year Treasury yield.
The 10-year Treasury yield is the yield or interest paid to investors who purchase 10-year Treasury notes. It rises and falls based on myriad factors, including inflation, monetary policy, and investor confidence. The 10-year Treasury yield helps investors track the cost of capital and financial market health. To understand why it matters, you must first grasp the bond market’s basics.
What is the Bond Market?
Bonds are debt instruments issued by a municipality, corporation, or country when they need to borrow money. Think of them as IOUs where one party lends money to the other party in exchange for getting paid some interest. Bonds backed by the U.S. government are issued by the Treasury Department and thus called Treasury bonds. To bring precision and order to the marketplace, you’ll see treasuries referred to as bonds, notes, and bills, depending on the maturity. Those that mature in less than two years are called Treasury bills. Treasury notes expire between two and ten years. Treasury bonds have a maturity beyond ten years.
The rate of return you receive when purchasing a bond is known as the bond yield. And, since there are so many bonds available, it’s customary to state the maturity before the yield, so you know which instrument you’re referencing. Thus, the yield on the 2-year Treasury bond is known as the 2-year Treasury yield; and the yield on the 10-year Treasury bond is known as the 10-year Treasury yield.
Bond prices and yields move in opposite directions. It’s an unbreakable mathematical relationship. Here’s a simple illustration:
Demand for bonds rises -> Bond Prices rise -> Bond Yields fall
Demand for bonds falls ->Bond Prices fall -> Bond Yields rise
What Affects the 10-year Treasury Yield?
There are three primary drivers of the 10-year Treasury yield: inflation, monetary policy, and investor confidence.
Inflation
Because buyers of long-term bonds, such as the 10-year, are tying up their money for so long, the expected inflation rate matters greatly. They need to receive a high enough return to offset the erosion in their purchasing power. For instance, few people would be willing to purchase 10-year treasury bonds yielding only 1% if inflation was averaging 5% because it would result in a negative real return.
Thus, as inflation rises, demand for bonds falls. That pushes prices down and yields up. This is why we’ve seen such a massive uptick in bond yields in 2022. Due to a perfect storm of supply chain bottlenecks, fiscal stimulus, pent-up demand from the global pandemic, and Russia’s invasion of Ukraine, inflation has ballooned to a 40-year high, killing bond prices along the way.
Monetary Policy
The Federal Reserve (Fed) has a dual mandate to fight inflation and promote full employment. Though they have various tools at their disposal to influence both factors, setting short-term interest rates is the most common one. The specific interest rate that the Fed sets is the federal funds rate, and it drives the cost of overnight borrowing by U.S. banks. When the central bank is more concerned about inflation, they lift the Fed Funds Rate to increase borrowing costs and tap the breaks on the economy. Alternatively, when employment becomes the greater concern, the Fed will lower the Fed Funds Rate to reduce borrowing costs, stimulate the economy and, hopefully, achieve full employment.
When the Fed Funds Rate changes, there is a domino effect throughout the interest rate markets. Rather than track interest rates across every maturity, traders tend to focus on the 10-year Treasury yield to see what impact movements in the Fed Funds Rate are having on longer-term interest rates.
Investor Confidence
Investor confidence is another driver of the 10-year Treasury yield. The bond market competes with stocks for capital. Historically, stocks offer higher returns, but also higher risk. Bonds, in contrast, offer lower risk, but also lower returns. When the economy is humming and investors feel confident about the future, they favor buying stocks over bonds. The lack of demand for bonds pushes prices down and yields up.
But when traders fear the future, the flip switches and risk reduction reigns. Demand for stocks falls while demand for bonds rises. That pushes bond prices higher and bond yields lower.
Why Does the 10-year Treasury Yield Matter?
Investors use the 10-year Treasury yield in many ways. It reflects investor expectations for the future path of inflation and the Fed Funds Rate. For instance, in June 2022, the target range for the Fed Funds Rate was 1.5% to 1.75%, but the Federal Reserve was forecasting it would continue lifting rates to around 3.5% by the end of the year. Meanwhile, the 10-year Treasury yield was trading at 3.2%, already pricing in the future path of rate hikes. It wasn’t trading any higher because investors didn’t believe the Fed would be able to lift rates beyond the mid-3% range for very long before pulling them back down.
Investors also use the 10-year Treasury yield as a benchmark for other key interest rates, such as mortgages or corporate debt. The historic doubling of mortgage rates from below 3% to over 6% in less than one year came on the back of booming Treasury yields. Tracking the 10-year yield throughout the economic cycle will better help you understand the interplay between interest rates and financial assets.
On the date of publication, Tyler Craig did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
