The closely watched U.S. treasury note yield has steadily moved up since the spring of 2023. This uptrend is a major shift from the first half when the rate traded in a range around 3.5%. The yield on the 10-year US treasury is a fundamental economic indicator; even small movements in the yield can have major impacts on financial markets and capital allocations. There are several reasons for the yield’s importance; understanding these reasons will help you understand the current major index price action.
Why is the 10 year Treasury Yield Important?
First, consider the fact the 10-year U.S. treasury is the benchmark upon which many sorts of borrowing and especially mortgage rates are set. The U.S. economy is a consumer driven system. In such a system, the cost of financing a home, the ability to refinance, and the general availability of affordable housing can have major impacts on the health of American consumers and their ability to purchase other goods and services which drive economic growth. Lower borrowing costs and a strong housing market are themselves major causes of economic expansion. Therefore, information that comments on the health of consumers, like the 10-year U.S. Treasury yield, is highly prized by market participants.
Second, the rate at which companies can borrow money is affected by the 10-year U.S. treasury yield. When borrowing costs for companies rise, the cost of doing business goes up. Less capital is available to allocate toward research and development, physical plant, and product and service expansion. These factors will be a drag on economic growth. Conversely, when borrowing costs decline, more capital is available for economic expansion. Therefore, the 10-year US treasury yield comments on the ability of companies to create economic activity.
Third, U.S. treasuries are considered some of the safest investments in the world because they are backed by the full faith and credit of the U.S. government which has never defaulted on its debt repayments. Foreign investors and governments are attracted to the U.S. treasury market when economic troubles, geopolitical tensions, and military conflict cause fear about economic stability and growth in overseas markets.
Finally, within the domestic economy, yields on the 10-year treasury will go up during times of high investor confidence because the demand for the security declines as investors seek more riskier investments like equities. Good economic times give investors confidence to take risks, so the demand for safer investments declines. A decline in demand leads to lower prices for treasuries which drives their yields upward. To the point, higher treasury yields are associated with good economic times. Pundits will sometimes refer to this scenario as a “risk on” trade environment. The converse scenario is when there is uncertainty in the economy which causes fear for investors. Fear causes investors to flock to the safety of treasuries. The demand for treasuries goes up which means treasury prices go up. As prices go up, yields fall. This is the “risk off’ trade.
How Does the Yield on the 10 year Treasury Get Set?
The federal reserve sells 10-year treasury notes to major banks and other financial institutions. The face value of every 10-year note is $1000. At the time of this sale, a coupon rate is set by the Federal Reserve. The coupon rate is interest that the United States government promises to pay at the end of the 10-year term. However, the story doesn’t stop there. Financial institutions can and often do sell their stockpiles of treasuries to other investors such as their clients. These second transactions make up the secondary market. When secondary market transactions occur, an investor can either pay a higher or lower price than the face value. The “risk on” vs “risk off” factors drive the secondary market dynamics. Depending upon sales prices in the secondary market, the effective yield is determined. If an investor buys the note at a price higher than face value, the effective yield will be less than the coupon yield. If an investor would buy the note at a lower price than face value, the effective yield would be higher than the coupon yield.
The effective yield is the yield. It is the yield we all speak of when we discuss the importance of the 10-year US treasury note. As a matter of fact, the effective yield is what gets plotted in a chart of the 10-year T-note yield. The secondary market is active each business day. As the demand for safer treasuries increases, so does the price which drives down yield. As demand for treasuries declines, price will also decline which pushes up yields. The yield data is plotted to become the yield chart we all love and fear as equity investors. Figure 1 shows a plot of yield data made with TradingView software for the year.
FIGURE 1 - A plot of daily effective yield data for the 10 year U.S. Treasury Note. Not the strong uptrend starting in the Spring of 2023.
How Does a Rising 10 year Treasury Yield Affect Equity Markets?
The days of very low interest rates seem long gone as the 10-year yield shown in Figure 1 above now seems to be threatening 5%. When considered via a historical perspective, interest rates are not drastically high right now. However, the federal funds rate had been near zero for most of the preceding 15 years. This situation represents a “new normal” for the United States economy. Part of this new normal involves how market participants interpret the 10-year treasury yield. While true that confidence and general good times for the economy are associated with higher treasury yields, at a certain point there is concern that investors will pull capital out of equities and park it in the safer treasuries. The precise issue seems to be treasuries are now not only a safe investment but one with an attractive rate of return. As the effective yield on the 10-year note has moved to just above 4.7%, we have seen equity markets pull back. Figures 2 through 6 below show recent downward moves in broad swathes of U.S. equity markets.
The Federal Reserve has been pitching the notion of "higher for longer"; it is a message that the market may not have fully priced in to this point. What was once a sign of comfort for equity markets, rising 10-year yields, is now a source of some uncertainty due to the shear amount of upward movement. The markets are going to go through an adjustment period; volatility during this time will likely be higher.
FIGURE 2 - A weekly chart of New York Stock Exchange Index price action. Note a recent sharp retracement to a primary support trendline. The beginning of the trendline is off the chart in 2011.
FIGURE 3 - A weekly chart of Wilshire 5000 Total Market Index price action. Note a recent retracement to a minor support trendline which is also where two moving averages converge.
FIGURE 4 - A weekly chart of Dow Jones Industrial Average Index price action. Note a recent retracement which breaks a support trendline established in 2020. The beginning of the trendline is off the chart.
FIGURE 5 - A weekly chart of S&P 500 Index price action. Note a recent retracement which is headed toward a support trendline established in 2020. The beginning of the trendline is off the chart.
FIGURE 6 - A weekly chart of Nasdaq Composite Index price action. Note a recent retracement which breaks a short term support trendline.
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