When the US government borrows money, the interest it pays is called the Treasury yield. It tells us how much the government is paying to borrow money, and how much investors earn through their investments in that government debt. The Treasury yield influences the interest rates that businesses and individuals pay for loans towards, equipment, property, vehicles, etc. The rational is simple. If the US government is willing to pay x% in interest, than a business or an individual that does not have the same power and credit as our country will need to pay more.
The US government is in charge of huge projects across the country, such as infrastructure. To raise capital for those projects, it issues debt instruments through the US Treasury. Depending on the scope of the project, it can issue Treasury bills (T-bills), which are short-term bonds that mature within 12 months; Treasury notes, which run up to 10 years; or Treasury bonds (T-bonds), which mature in 20 or 30 years.
What influences the Treasury yield?
Because Treasuries are backed by the US government, they are considered low-risk investments. When you purchase a Treasury, you loan the government the face value of that treasury, and the government pays you interest. These interest payments are called coupons and represent the government’s cost of borrowing money from you.
However, these coupons are not your yield. Treasuries are sold at the initial auction or on the secondary market to the highest bidder. Therefore, demand drives the price of the Treasury, which can even exceed its face value. In other words, investors may pay more upfront for the Treasury to get the coupon. Because the government repays only the face value on the maturity date, the investors gets a lower total yield.
Let’s look at an example. If you purchase a Treasury bond for $10,000, you will receive $10,000 when the bond matures. If however, you purchased this bond for $10,090 in the open market will still be repaid only the face value of $10,000 when it matures. In this case, you are willing to pay $90 on top of the bond repayment to get the coupon. This $90 is subtracted from the coupon to get the final investor yield. When the Treasury yield falls, lending rates for consumers and businesses also fall.
On the other hand, Treasures may be sold at prices lower than face value if demand is low. In those cases, the Treasury yield is effectively increased to compensate for the low demand. Investors are only willing to pay a price below the face value, and this increases their yield because they practically get a discount on the Treasury but get paid the full face value upon maturity. In other words, the government must pay higher interest rates to attract lenders, and this increases interest rates in the general economy.
Treasury terms and yields
Normally, longer-term Treasuries have a higher yield than shorter-term Treasuries. For instance, a 20- year bond would have a higher yield than a 5-year bond. The reason behind this is a combination of positive expectations about growth and inflation, and the assumption that more adverse economic events are more likely to take place over a longer period. The risk is higher for long-term Treasuries, so investors are compensated through higher yields.
If, however, investors expect problems in the economy in the short term, the demand for short-term Treasuries will drop. Investors will sell them off faster than longer-term Treasuries because they foresee slower short-term growth. As a result, the yields on short-term securities increase. These yields may exceed long-term yields, and if that happens, we experience what is called an adverse credit event. Generally, this causes the yield curve to flatten or even invert. Such a situation is a sign that we are headed towards a recession
What is the situation today?
Let’s take a look at the graph. It shows the difference between the short 2 year treasury yield and the long 10 year treasury yield. The orange line indicates the point determined by the Federal Reserve where the probability of a recession is increased. This is where we were in 2006—we saw a negative spread between yields, which was the first hint of a recession—and in December 2007, the recession began.
Today, it looks like we may be heading that way again. What strengthens that outlook is the fact that if we look at the Federal Reserve’s interest rate hike cycles, only three such cycles in the past 100 years have not resulted in a recession. There is no reason to panic at this moment, but we shouldn’t ignore that our current situation is a cause for concern.