Hey Psychos! In the past few days we have received a bunch of questions regarding Treasury yields and their effects on the market so we decided to make this small write-up explaining the situation. While this is by no means a comprehensive list or a very detailed explanation, we hope it helps you understand the broad strokes of what is happening.
To start, Treasury yields can be thought of as the return on investment the US government pays on its debt obligations, such as bonds. The government sells Treasury bonds to raise money and investors or financial institutions buy them because they are considered relatively risk-free investments, given they are backed by the full faith and credit of the US government.
How do rising Treasury yields affect the stock market? Basically in two ways; 1. as yields rise, bonds become more attractive for investor dollars (meaning bonds compete with stocks for investor’s money), and 2. interest expenses go up, making it more expensive to borrow money. This is why high-flying tech stocks have been particularly battered by rising rates.
Finally, why are Treasury yields are suddenly rising? Again, this is a very complicated macroeconomic question with a multitude of factors but very basically, Treasury yields rise when the demand for bonds is low in order to make them more attractive for investors. Now we need to understand why the demand for bonds is so low.
- More stimulus is likely coming. One of the main ways the US government is able to raise money for massive programs like stimulus they issue a whole lot of bonds, which the Federal Reserve has been buying up. This affects the demand for bonds because why would an investor buy a bond now if they know that in the near future there will be a bunch of new Treasury bonds flooding the market soon because of stimulus, lowering the price (remember a spike in supply leads to a lower price)
- Belief that strong growth is coming to the US economy. Now, this is a little counter-intuitive but if people believe that the US economy will strongly rebound from the coronavirus pandemic, then demand for low-return, risk-free investments like Treasury bonds is low (The logic is why would someone buy a 10-year bond that pays let’s say 1.5% interest per year when they can make a greater return by investing in stocks). But then, because the demand for bonds is so low, the yields start to rise which then makes equity pressured because of the higher cost to borrow capital. However, if one thinks the economy will continue to grow, then stocks will remain more attractive than bonds. This is a heavily-simplified version of Jerome Powell’s argument during his testimony early in the week.
- Inflationary Fears. If people fear that inflationary pressures are coming, they are extremely unlikely to buy a low-return asset like ab bond because they will either make no money or actually lose money through inflation. For example, if the inflation rate is 3% and I own a 10-year Treasury bond with 2% yield, then I’m actually losing money by holding the bond.
Thoughts of a Psycho Trader…