What Rising Treasury Yields Mean for the Economy

ladies and gentlemen welcome to the plane Bagel I'm your host Richard coffin there's been a lot of hoopla over the past few weeks over Rising treasury yields not just from news outlets but also more importantly fin twit uh the finance space on Twitter where a lot of people are talking about the fact that the US Treasury yield specifically for 10-year treasury bonds reached a 16year high of 4.8% mid last week with 20 and 30-year bonds likewise seeing their yields move higher now as you might know yields have an inverse relationship with bond prices as yields move higher bond prices for existing debts that have already been issued tend to fall and the movement we've seen in yields and bond prices actually represents one of the most drastic sell-offs of US Treasury bonds ever with Bloomberg reporting that as of March 2020 bond prices for treasuries with maturities of 10 years and higher have fallen 46% which is crazy when you consider that theoretically treasury bonds the uh instrument that pays the treasury yield issued by the US government is considered one of the safest passet classes for investors and yet the Fallen price we've seen for treasury bonds is in line with past stock crashes namely around the 2008 financial crisis and the dotc crash and speaking of stocks the news around Rising yields has caused a selloff there as well while prices have recovered this week since July the S&P 500 has generally been on the decline with many blaming the rising yields directly for causing stock prices to fall and while yields have recently pulled back from their peaks of last week we've had a lot of people really sounding the alarm mning that yields can go significantly higher from here that things are going to crash all across the board and we were headed for a crisis similar to what we saw earlier this year with the collapse of several Regional US Banks and so with how sensationalized things have become I've been summoned once again uh to help explain the whole situation give all the details and make it boring now to be clear Rising yields do present risks to the economy and historically they have been followed by recessions so in this video I'll explain that link as well as why stocks might be impacted and why people are making that comparison to earlier this year with the regional banking crisis but also try to Prov provide other details that hopefully paint a more holistic picture again as always not to tell you one way or the other how things are going to turn out but just to give all the details that you won't necessarily get in uh 280 characters or less also try to make this video beginner friendly and cover some basics of how yields work and how they influence uh market performance uh but if you aren't interested in that sort of stuff I will also divide the video into chapters so you can skip ahead to the more recent details without further Ado let's talk about everyone's favorite topic treasury bonds I'll start by the link between Rising interest rates and Rising treasury yields because if you're a casual consumer of the news you might be thinking to yourself what's the big deal uh we've heard about Rising interest rates for the past two years now rates are rising and and people are calling for the collapse of the US economy doesn't make a whole lot of sense but to be clear there is a difference between treasury yields and those interest rate hikes again we've been hearing about for the past two years they do go hand inand uh but there are some nuances to understand about the two when we talk about those interest rate hikes we've been having that's specifically referring to increases in the federal funds Target rate uh the interest rate charged on overnight loans between Banks so very short-term debt within the finance sector and the idea with increasing the short-term rate is that eventually it will push up other interest rates in the economy if banks have to pay themselves about 5% to borrow money overnight but when we talk about treasury yields we're referring to a market determined rate for buy government bonds specifically longer term government bonds outstanding for 10 years and high and again treasury yields are largely Market determined meaning they can't really be set such as the federal funds Target rate the coupon rate for the bond stays the same so if you have a 1,000 face value Bond paying a 5% coupon that's $50 a year that that Bond will always pay but because you might be able to buy that bond for more or less than $11,000 the rate of return you get as a buyer at say $900 is going to actually be higher than that coupon rate because you're getting that $50 for less than $1,000 that's a better rate of return and when interest rates rise for new debts again prices for outstanding bonds will fall so that their yields become more attractive to buyers who now face this alternative of just buying these new debts instead but while shorter term bonds adjust rapidly to higher rates uh in part because they renew a lot quicker if you're only lending money out for 3 months after 3 months time you're going to adjust the rate to the market rate the influence of rate hikes on longer term bond yields can take more time meaning the yield may rise more slowly in part because those debts are outstanding for longer so those coupon rates don't renew us quickly because of this Divergence where shorter-term bond yields increase a lot faster to rate hikes than longer term bond yields you can end up with what we've had over the past year and a bit which is an inverted yield curve which all that means is that if you graph all the different bonds based on their time to maturity uh with their yield on the y- AIS you can see that shorter term bonds are actually paying more to investors than longer term bonds which as you might know is a little backwards uh it tends to be that the longer a debt is outstanding the more interest rate the lender will demand because it comes with higher risk and more opportunity cost so since the second half of 2022 as rates have been hiked the yield curve has been inverted now that those longer term yields are rising we're starting to see the curve normalized which just means that it's slowly returning to that typical upward slope so what is it about right now that's causing these longer term yields to rise that's causing investors to sell their bonds into the market pushing prices down and pushing again these yields higher uh well part of it is just that normalization of the yield curve because you have that long-term relationship ship where longer term yields will have a higher interest rate than shorter term yields over time as things settle you will see the movement back to that normal state in fact if you graph the yield curve over time which a lot of people do by taking the single data point of the 10-year yield subtracting the 2-year yield uh you can see that inverted yield curves where that number is negative only typically last for a short period of time before the curve normalizes and a big part of this normalization step is simply changing Market expectations inverted yield curves can exist when investors expect a near-term rate rate cut or otherwise an economic recession of sorts uh with the idea being that while they can hold a shorter term bond and earn a better return than if they held on to their longer term bonds they're not willing to yet sell those longer term treasuries uh because they're a safer asset and sure they might only pay 2 to 3% but that's better than going into a short-term Bond only to then after a year needing to find a new investment in perhaps a worse environment but now it appears that that view is changing mostly in part thanks to Stubborn inflation uh which has really refused to move below the 3% level actually bouncing back up from that point and the reason why things seem to have come to a head last week and why yields reached a high at that point is because we had a lot of Labor data released that seemed to point to a still hot labor market something that can lead to wage inflation and as we've got these data points suggesting that the econom is still running relatively hot we've gotten a lot of uh signaling from the Federal Reserve that they intend to keep rates higher for longer specifically indicating that another rate hike was possible so that's a big part as to why we're seeing longer term yields rise now we've had these rate hikes but this is really the market coming to terms with those rate hikes and somewhat accepting that we're going to have higher rates for a longer period of time that they aren't necessarily going back to where they were before anytime soon and because of that investors aren't going to be as willing to hold on to a 10 plus year bond that's only paying a 2% yield on what they originally bought it for which is why we're seeing the selloff of longer term bonds now with all that being said there are some other influences as play here as well that could also be contributing to these Rising long-term yields with one of them being that at the same time the Federal Reserve is increasing interest rates we're also seeing this quantitative tightening policy where the Federal Reserve is taking all the bonds it bought during the pandemic and beforehand which were done at that time to actually lower the yields on longer term bonds they've since stopped that demand and are now letting those Bonds mature and importantly they're not pursuing active quantitative tightening at this time which means they aren't selling those bonds back onto the market but nonetheless we have one of the biggest buyer of bonds being pulled out of the market secondly in August the US actually did have a credit rating downgrade uh meaning that their Bonds were deemed as being riskier something that again can cause investors to demand a higher return to buy these bonds with Fitch the credit rating agency behind the downgrade citing among other factors growing deficits uh which importantly in the US are actually funded with the issuance of government bonds so with the supply side of government bonds likely to increase as well that again will have an influence on yields likely pushing down prices and thirdly again on the demand side I have seen some speculate that we're seeing less demand from countries like China China Parks a lot of the US dollars that it gets from Trading with the United States in treasury bonds so that it earns a bit of a return but with trade actually being down and the country grappling with an economic slowdown some believe that that country is buying fewer bonds uh that's a bit harder to confirm but again could be an influence there but regardless of the cause longer term yields have risen and may move higher still since our yield curve is yet to be at a properly normal curve and this movement can cause some economic pain in fact if you graph the two versus 10year treasury yield you can see that inverted yield curves actually tend to be followed by recessions the gr out area so with us now in that normalizing step of our own inverted yield curve many are predicting that a recession is coming uh that ever so elusive recession that we've been we've been waiting for for the past couple years but to be clear this isn't just a loose connection there are practical explanations as to why Rising longer term yields can have a negative impact on the economy and Investments with the first one being that Rising longer term yields directly increase the cost of longer term borrowing treasury yields are actually used frequently as a reference rate for other interest rates again because uh they're technically considered risk-free even though there's debate around that so as these floor interest rates increase they're going to push up interest rates for similar maturity debts uh as an example if you actually superimpose the 30-year mortgage rate over the 30-year treasury yield you can see that they are pretty strongly correlated with Rising mortgage rates actually being one of the most talked about casualties of the recent spike in yields given that 30-year mortgage has recently reached a 23-year high so that means that as treasury yields increase Consumer Debt is going to become more expensive such as with mortgages like we've talked about uh corporate borrowing is going to become more expensive with companies now having to pay more when they renew their debt or if they want to borrow more money to perhaps explore expansion projects whatever have you which is going to impact their profits and maybe force them to cut costs and of course we can't leave out that it directly makes government debt more expensive this is quite literally the cost of government debt that the government has to pay on its own debt load and with the government having a record debt pile of $33 trillion and an average interest rate of just 3% those higher yields are eventually going to be pushing the share of their money that they pay towards interest expenses higher and higher now there's debate to be had about whether the US government could technically default outside of you know political squabbling given that their debt is US dollar denominated but nonetheless you might still have politicians coming forward looking to pull back spending possibly even increase taxes to try and reduce that that deficit and all these things combined less spending from consumers less spending from corporations and less spending possibly more taxing from the government are all negatives for economic activity so that's why some might believe the economy will experience a recession while we see these Rising yields the other impact that we could see is money being pulled out of other Investments when it comes to stocks and other opportunities treasury yields are a bit of an opportunity cost because to buy this stock you have to give up this fixed rate of return you could simply lock in by buying a longer term treasury so as that opportunity cost increases where you could just lock in a higher rate of return for 20 years or whatever it's going to make other Investments less attractive possibly causing investors to sell out which could deflate those asset prices this is especially true for growth companies where a lot of their value is tied to their future profits uh which with a higher treasury yield are going to be discounted at a heavier and heavier rate um meaning that again those companies become less attractive so not only might stocks see a decline because fundamentally they're seeing their profits squeezed thanks to higher interest expenses but you might also see that valuation contraction where investors are pulling money out of the space as well thereby causing prices to fall now a third impact I'll quickly touch on here is that Rising yields do tend to strengthen the US dollar which isn't necessarily negative across the board uh but it does come with some friction that will hurt certain players uh for example International companies that are based in the US and operate in US dollars but earn a lot of their revenues overseas or in other countries because they're facing a less attractive exchange rate converting those foreign currencies into a US dollar that can hurt their profits as well and for foreign countries especially those debt ladened with US dollar debt this can be really painful for them because again they are on the other side of that exchange rate and face a more expensive debt payment to pay off that US debt and finally the fourth impact which is really the more acute concern for many is how these Rising yields will be bad for US Banks uh you might recall that earlier this year we again saw the collapse of a number of us Regional banks with a big Catalyst for that being the riseing interest rates of the time over time higher interest rates actually tend to be good for banks they're able to charge more for their own loans which as you would expect increases their net interest margin and their profitability the problem is that a lot of these banks have their assets tied up in long-term bonds paying yields at times of less than 1% which means that as these yields are rising those assets are actually falling in price if they want to sell these bonds onto the market say to meet customer withdrawal needs they're likely going to experience a loss because these bonds are now significantly less attractive if you try to sell an investor a 1% Bond when other bonds are paying 5% you're going to have to sell it at a significant discount and this is really what happened with Silicon Valley Bank they had to run on their deposits where they had to quickly increase the cash they had on hand and the assets they had had fallen so much in value that they actually couldn't meet customer withdrawal needs and that was when the 10year treasury yield was at 4% now that we're pushing to 5% you can see why some are ringing the alarm Bells these companies are already sitting on sizable unrealized losses that will only get bigger if yields continue to rise with Bank of America being one of the worst examples of this with an unrealized loss of over $100 billion so that's why people are nervous it's not really that the economy could never handle a 5% interest rate or you know higher still it's more so with how quickly rates have risen to try and combat inflation which is an important thing to pursue but many are concerned that this will come at a significant cost in that more things in the economy will break given how long things were functioning at Rock Bottom interest rates and how quickly things are now being pushed out of that environment nonetheless there are still some other things worth considering here uh with one of those things being that the market is still actually pricing in a moderate decline of interest rates uh meaning that most people still believe that rates are going to be cut in the near- term further Financial Times future markets are still pricing in two or three interest rate cuts which is still down from early September but still nonetheless shows the market doesn't fully believe that we're going to keep rates where they are for longer and while this doesn't mean that there won't be pockets in the economy that suffer again the reason Li lot of investors are selling their longer term treasury bonds is because they don't feel as much of a need to hold on to that safe haven investment which could be interpreted to mean that investors do believe the economy can somewhat handle the higher rates we've seen not that the market has always been uh rational and right in the past but just something to keep in mind secondly there is still the chance that we see inflation moderate and we don't have as much of a need for these higher rates while there were CPI figures released this week that were higher than expected they still did point to at least a stagnating infl rate albeit to a much lesser degree than initially hoped for thirdly when it comes to Banks specifically it's worth highlighting that the industry hasn't been standing idly by since March banks have actually been building up their reserves which would help them absorb some losses we still have more tools now from the Federal Reserve in different agencies than we did back in March such as the bank term funding program which essentially allows Banks to avoid realizing those Bond losses until at least March of 2024 and as I highlighted in a past video where I compared the big US Banks to Silicon Valley Bank uh by looking at their finances the post postmortem of the bank really showed a lack of risk management that you're unlikely to see with the larger institutions for example if you look at Bank of America they have a significant derivative portfolio targeted at interest rates which means they're likely using these instruments to at least in part hedge some of that interest rate exposure which Compares a silon Valley Bank who had a tiny derivative portfolio and with the larg banks you really are less likely to see that sort of run on deposits that really pressured these Regional Banks thereby reducing the risk that they would need to realize those losses and while a less optimistic point I will highlight that bank crises do tend to be highly deflationary uh so if something does happen higher rates won't be as needed and then really ties into my final Point here which is that it's not just how high the rates get but also how long they stay there and there's really no predicting that yes we do have this uh signaling from the Federal Reserve but they do that intentionally to try and pull back expectations from the market which itself can help fight inflation so although Federal Reserve is signaling one thing they could very well pursue a different path um and as we see different data points coming out that hopefully point to lower inflation that will you know increase the hope that the Federal Reserve will cut rates sooner than later nonetheless I do want to be clear that Rising rates do present a real risk to the economy and unfortunately with how complicated things are even within the finance system itself it's really difficult to predict what will happen from here uh history has shown that a lot of the time we see a recession after an inversion of the yield curve and the following normalization but as of past videos I'll highlight that if you're Diversified and you're focusing on the long term you will generally have that tolerance to WEA whatever the economy throws your way so unless you've been taken on significant risk and haven't been as diligent with your investment strategy it doesn't mean that you should be losing sight of your long-term strategy anyway we'll have to wait and see but that's a video thank you for joining me today if you like this video please do make sure to like subscribe all that good stuff it does help the channel tremendously and let me know your thoughts on the situation if you are more optimistic less so uh maybe you are more Doom and Gloom whatever it be happy to hear from in the comments down below and it helps a channel sorry that's my child anyway on that note I'll sign off and until next time be safe out there

Channel: The Plain Bagel

Views: 355,622

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Length: 18min 8sec (1088 seconds)

Published: Fri Oct 13 2023