The 10-year U.S. Treasury Bond is clearly the highest profile benchmark for the U.S. bond market. When I wake up each morning, I check all the financial markets, and the “10 year” is high on my follow list. Since the beginning of 2021 the 10-year U.S. Treasury bond has been telling us something. The question is what?
From a low point yield of 0.51% in August 2020, the 10-year US Treasury rate sits as I write this column at 1.38% (source: Bloomberg). While some may look at this change and yawn, thinking “what does it matter if a 10-year bond yields half a percent or one and half percent, both are deplorably low,” it’s the move in the yield that has investors concerned and is probably behind some of the stock market volatility of the past two weeks.
When it comes to the bond market there are two types of stress points we can observe. The highest profile is obviously yield, or interest rates, and as mentioned the 10-year U.S. Treasury Bond is the most often used metric for interest rates.
The second stress point is called credit spreads, which refers to the difference between what the 10-year U.S. Treasury yields and other types of bonds yield. U.S. government bonds are considered to be the default risk-free benchmark, and so we would expect the yield to be lower than the yield on other bonds which involve more credit risk. The most widely followed indicator for credit spreads is the spread between high yield, or lower credit quality bonds, and U.S. Treasuries. When we look at credit spreads over the past six months (since August 2020), the spread has actually shrunk from 2.7% to 2.1% today (source: St. Louis Fed).
So, what does all this potentially mean? Well, yield, or interest rates, in its purest form is an indicator of economic growth and potential inflation. Yields will traditionally trend higher when investors feel the economy is likely to grow and prices on goods and services are likely to go up as a result. A move from 0.51% to 1.38% could be logically construed as investors getting more comfortable with the post COVID economic recovery.
On the same side of the coin, credit spreads are also an indicator of investor confidence in the economy. If investors feel the economy is weakening, they become more concerned about companies defaulting on their bonds and they demand more yield for purchasing those bonds. The opposite can be said if investors feel the economy is likely to grow, in which case default risk goes down and credit spreads tighten, aka get smaller, as well.
What we have at this time is bond yields going higher and credit spreads getting narrower, two indications that investors are anticipating a decent post COVID economic recovery as vaccines are deployed. This all makes sense, but here also ends the “academic” lesson in bond yields.
In the real world, the financial markets are being highly manipulated by the Federal Reserve, and the economy is about to get another huge jolt of economic stimulus from the Federal government. Since the dark days of March 2020, the US Federal Reserve has been conducting “asset purchases” of billions of dollars a month, and according to Fed Chairman Jerome Powell this week, these asset purchases are not ending anytime soon.
If you’re confused by the term asset purchases, I understand, it just means the Fed is creating brand new money (yes, out of thin air) and injecting it into financial markets. This strange process is being conducted for the specific purposes of keeping credit spreads low and more importantly, bond yields at targeted levels.
Which tells me something else may be afoot in the bond market. I think investors are nervous about the size and methodology of the $2 trillion stimulus plan currently working its way through Congress. While the stock market hungrily awaits these stimulus dollars, the bond market is saying “we aren’t sure it’s a good idea.”
I tend to agree; all signs point to a strong re-opening economy as COVID passes. With the Fed and the government pouring stimulus on the economy, the value of the dollar itself could be put at risk, which could lead to inflation. While the stock market is certainly getting all the attention right now, the bond market is sending a mixed message. Wise investors will be watching both.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stock investing includes risks, including fluctuating prices and loss of principal. Marc Ruiz is a wealth advisor and partner with Oak Partners and registered representative of LPL Financial. Contact Marc at firstname.lastname@example.org. Securities offered through LPL Financial, member FINRA/SIPC.