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[Insights for Oct. 2023]Navigating the Volatility of US Treasury Yields
This article contains 1000 words and takes about 2 minutes to read.
In early October, there were significant fluctuations in US Treasury bond yields.
● On October 3rd, the yield on 10-year bonds rose above 4.5% for the first time since the global financial crisis in 2008, reaching a new 16-year high. At the same time, the S&P 500 index dropped to a four-month low.
● However, the situation changed dramatically on October 10th when Federal Reserve officials hinted towards a sustained interest rate. The US Treasury yields reacted negatively, marking the biggest single-day drop since March this year.
● On October 12th, the US Treasury Department announced that it had sold 30-year bonds at a yield of 4.837%. However, the auction was disappointing, and this caused US Treasury yields to sharply rise and stock markets to fall.
What's behind the rollercoaster-like fluctuations in US Treasury yields, and how should the market react? This macro analysis breaks down the analytical logic behind US Treasury yields.
Basics of government bonds
Let's take a closer look at the rise in US Treasury yields and its effect chain.
US Treasury bonds are essentially loans given to the federal government with maturities ranging from a few weeks to as long as 30 years. Treasury bonds are part of the larger category of U.S. sovereign debt known collectively as Treasuries, which are typically regarded as virtually risk-free since they are backed by the U.S. government's ability to tax its citizens.
The formula for calculating bond yield is Bond Yield = Annual Interest Payment / Current Market Price. The yield of government bonds exhibits an inverse relationship with their price, indicating that when the bond prices rise, the yield falls and vice versa.
When the yield increases, it signifies a decrease in investor demand for government bonds. In such situations, investors may choose to opt for higher-risk, with potentially higher-return investments. Conversely, a decrease in yield suggests a surge in demand for government bonds, indicating that investors are seeking low-risk, low-return investment options.
What factors can affect the US Treasury yields?
We can categorize the most important factors affecting US Treasury yields into the following categories:
Investor confidence: When investor confidence is low, bond prices tend to rise, leading to a fall in yields. This is because investors tend to seek safer investment options such as government bonds during times of uncertainty, resulting in a decrease in yield as a sign of market caution.
Monetary policy: The federal funds rate acts as the benchmark for other interest rates and has a direct impact on US Treasury yields. Therefore, if the Federal Reserve increases interest rates, US Treasury yields also tend to rise.
Economic indicators: Unexpected results from economic indicators can have a significant impact on US Treasury yields. For instance, during a period of inflation control, if the CPI, PCE, or employment report data exceeds market expectations, it signals a healthy state of the economy that can support further interest rate hikes by the Fed. This expectation of interest rate hikes can cause a significant increase in US Treasury yields.
Unexpected events: Geopolitical conflicts and wars can lead to short-term fluctuations in yields, driving investors to look for safety in the bond market, causing a drop in yields. Some political events in the US can also influence US Treasury bonds. For example, geopolitical conflicts surrounding oil regions could lead to an increase in inflation expectations, resulting in higher-for-longer interest rates and potentially leading to the return of a traditional risk premium for bonds.
What potential impacts of a sharp rise in US Treasury yields can have?
Looking ahead, economic stability will likely be the most crucial factor to monitor. This is because high-interest rates sustained over a long period not only worsen concerns about US inflation but also raise expectations of interest rate hikes by the Federal Reserve.
If economic data exceeds expectations, it could show that the US economy has strong resilience and lead to the market believing that high inflation would persist for an extended period and the Fed would postpone cutting interest rates.
As reported by Reuters, the increase in government bond yields has the potential to negatively impact the US economy, causing it to slow down more than anticipated by Federal Reserve officials. It may also result in an increase in borrowing costs and larger deficits for the Biden administration, creating new challenges and variables for the economy and the 2024 presidential elections. These factors might force the Fed to rethink some of its long-term plans.
It's worth noting that the longer the maturity of a government bond, the higher the yield, as investors expect greater returns for their funds being tied up for a longer time. A normal yield curve typically shows that the yield of short-term debt is lower than that of long-term debt. However, sometimes the yield curve may invert, with shorter-term bond yields being higher, indicating an impending recession.
Having said that, some may wonder what the current US Treasury yield curve looks like.
As we can see, the US Treasury yield curve is clearly inverted.
It's evident that the US Treasury yield curve has inverted, with the 2-year and 10-year US Treasury bond yield inversion having lasted for 15 months since July 2022. Although this inverted yield curve has flattened slightly in recent times, the market perceives it as a warning signal of an upcoming recession. When the 2-year and 10-year bond yield curves de-invert and bonds are sold off significantly, it tends to indicate an economic downturn is approaching soon.
Founder of DoubleLine Capital, Jeffrey Gundlach, remarked that the -108bp basis point differential between the 2-year and 10-year bonds from a few months ago has now become -35bp. The rapidly flattening yield curve suggests a potential US economic recession.
Regarding the impact of yields on the financial market, some analysts have also shared their views:
While investors may search for opportunities in the fixed income market, Morgan Stanley's co-chief investment officer for global balanced and risk control strategies, Jim Caron, advises against going long on bonds. With the 10-year bond yield fluctuating within the range of 5%, he recommends "increasing duration" or unwinding bond short positions instead of investing in long bonds.
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