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Discover the bond market: A quick and easy guide
In recent times, the global financial markets have been experiencing instability as US Treasury yields continue to surge. This has resulted in volatility within the world's largest bond market and raised concerns among some investors about what rising yields signify and how inflation or the Federal Reserve's monetary policies are connected to Treasury yields.
To shed light on these issues, we will be looking at a significant component of the fixed income market that often influences the global economy - the bond market.
Key points to know about US Treasuries
Inflation? Interest rates? What factors can affect Treasury yields?
The pattern of changes in term premium for Treasury bonds
How can the inverted yield curve help forecast recessions?
Understanding the specific terms of bonds can be very useful, as they can differ significantly from those used in the stock market.
Types and Characteristics of US Treasuries
Let's begin with a question: which country has the world's largest fixed-income market?
The answer is not hard to guess-it's the United States. As of 2023, the total value of the US fixed-income market has exceeded $51 trillion, which accounts for 41% of the global market.
Thanks to its sheer size, the US bond market is widely considered the most liquid and efficient in the world. It not only reflects the dynamics of the global financial market but also usually affects the pricing of other asset classes.
The US bond market comprises several product classifications, such as government bonds, corporate bonds, municipal bonds, and mortgage-backed securities. Of these, US Treasuries are considered the most significant type. As part of US sovereign debt, they are widely viewed as nearly risk-free as they are backed by the US government. This feature makes them a preferred investment option for interest rates among large governments and individual investors around the world.
US Treasury bonds are used by the federal government to finance its spending, and they have different repayment terms ranging from 1 month to 30 years. These bonds are categorized into short-term Treasury bills (1 year or less), medium-term Treasury notes (2-10 years), and long-term Treasury bonds (over 10 years).
The interest rate that the government pays for its debt is known as the Treasury yield, which reflects both the cost of funding for the government and investors' expectations for the economy's future outlook.
Short-term Treasury bill rates are the most sensitive to changes in monetary policy, and their fluctuations are often more significant than those of long-term Treasury bond yields. The medium-to-long-term Treasury bond yields include a "term premium" based on investors' expectations of the US economic situation in the future, added onto the short-term Treasury bill yields.
Therefore, changes in short-term Treasury bill yields could affect the medium-to-long-term Treasury bond yields.
Many people wonder if the rise in US Treasury yields affects the burden of US debt.
The answer is not necessarily. The issue with US government debt is not the primary factor in pricing US treasuries. Changes in US Treasury yields do not impact the outstanding debt's cost since the cost of issuing US Treasury bonds by the US Department of the Treasury is fixed at the time of issuance. As interest rates increase and the national debt grows, future borrowing costs will likely rise. However, higher yields could potentially decrease the nominal value of US debt.
In the secondary market, bond value is determined by their price and yield, which are inversely proportional.
Current yield of bond = Annual payment divided by the current market price.
Understanding this relationship is crucial for potential success in bond investment. When bond prices rise, yields decrease, and when bond prices fall, yields increase. An increase in yield indicates lower demand for Treasuries, and investors may turn to higher-risk, higher-return investments instead.
To break down the factors that affect Treasury yields, we can categorize them into several areas.
Investor confidence: When investor confidence levels drop, bond prices typically increase, and yields decrease. The reason behind this is that in times of uncertainty, investors tend to flock to comparatively safer investments such as Treasuries, leading to a decrease in yield.
Monetary policy: Although we consider the 10-year Treasury yield as a benchmark for most interest rates, it can also be affected by changes in short-term rates. For example, when the Federal Reserve raises interest rates, the federal funds rate increases, which has a direct impact on Treasury yields.
Inflation expectations: US Treasury yields can be divided into real interest rates and inflation expectations, and market expectations for inflation may significantly affect the rise and fall of yields. Moreover, unexpected economic indicators at the time of release could also significantly affect Treasury yields. For instance, during periods of inflation control, when CPI, PCE, or non-farm payrolls exceed market expectations, it means that healthy economic conditions support the Federal Reserve's further interest rate hikes.
Emerging events: Geopolitical conflicts and wars can cause short-term fluctuations in yields. In times of uncertainty, investors may seek refuge in the bond market, leading to a decrease in yield. Conversely, geopolitical tensions involving major oil producers may raise inflation expectations, putting upward pressure on Treasury yields.
Widely-Watched Bond Market Indicators from Macro Perspectives
For new investors interested in bonds, tracking key indicators can offer insights into market conditions and investor sentiment. These indicators include:
10-year Treasury yield: This is the government debt instrument most widely tracked in the financial industry. Its yield can be used as a benchmark for other interest rates, such as mortgage and corporate debt rates. This yield is also considered a sign of investor confidence in the market.
US Dollar Index: As the world's reserve currency, the trend of the US dollar has a significant impact on the US bond market. When the dollar strengthens, overseas investors may turn to the US bond market, which increases bond demand, lowers bond prices, and pushes up yields.
CBOE Volatility Index (VIX): This index reflects the market's expectations for the volatility of the S&P 500 Index in the next 30 days. When market risk appetite decreases, and investors' concerns intensify, the VIX rises, generally pushing up demand and prices for safe-haven assets such as US Treasuries.
The yield of a Treasury bond increases with its maturity. Generally, investors expect higher returns for keeping their capital tied up for longer periods.
Generally, short-term debt has lower yields than long-term debt. Thus, if we plot the yield curve for bonds ranging from 1 month to 30 years on the x-axis, it should show an upward-trending curve, also known as a normal yield curve.
However, there are times when the yield curve inverts, meaning that the yield on shorter-term bonds exceeds that of longer-term bonds. In such cases, the yield curve takes on a downward slope, which is known as an inverted yield curve.
Currently, the US Treasury yield curve is inverted, with the 2-year and 10-year yields remaining inverted for the past 15 months.
The recent rise in yields can be attributed to the Federal Reserve's tightening monetary policy. To combat high inflation, the Fed has raised benchmark interest rates 11 times from March 2022 to October 2023, expanding the range to 5.25% to 5.50%, which is the fastest and strongest round of interest rate hikes in history.
The Fed's aggressive rate hikes seem to have made many investors uneasy, fearing that they could slow down growth or even lead to a recession.
In this case, investors tend to seek refuge in long-term Treasuries, pushing up their prices and lowering their yields. This is why the yields on long-term bonds, such as 10-year bonds, are lower than those on short-term bonds.
From an economic perspective, an inverted yield curve is a rare event that signals long-term concerns. This trend is disadvantageous for most banks as they rely on paying short-term interest rates to depositors and earning interest from long-term loans. As a result, an inverted yield curve can inhibit their profitability since they pay more but receive less in return.
Historically, the difference between the 10-year and 2-year Treasury yields has served as a precursor to an economic recession. When the yield curve is normal, the difference is usually positive, indicating future economic stability. However, when the curve is inverted, the difference is negative, indicating potential economic deterioration. The negative spread between 10-year and 2-year yields has historically preceded a recession within 6 to 24 months. This pattern accurately predicted every recession from 1955 to 2018, making it a leading indicator in the market.
The Chicago Fed's chart shows that since the 1970s, the yield spread has been negative before each economic recession, with the shaded areas representing each recession. Therefore, an inverted yield curve, indicating short-term interest rates higher than long-term rates, is often seen as a warning sign of an impending economic recession.
Currently, the US Treasury yield curve is gradually flattening, leading to a convergence among yields. However, the market still perceives this trend as a warning sign, since a reversal of the yield curve between 2-year and 10-year Treasury bonds often precedes significant bond selling, which is typically seen as an indicator of an impending economic recession. Campbell Harvey, a finance professor at Duke University, forecasts that a recession will likely occur in the first or second quarter of next year, which could pose significant risks to the financial system.
Check out the macro analysis in the "Advanced" section to learn more about the US bond market. Update yourself with the latest data and market trends to make more informed investment decisions!
