Plain Sense Economics

Pretty exciting title for this post, huh?

I get little news snippets sent to me, via email, from the Wall Street Journal. Here’s one that arrived this morning.

The 10-year Treasury yield, the benchmark for U.S. consumer and corporate borrowing, rose to 4% for the first time since June.

The move extends a steady increase by Treasury yields, which move inversely to prices, lifted by a combination of stronger economic data and the barrage of debt issued by the government to meet its financing needs. Recent Treasury auctions have met with much weaker demand and Monday’s move comes ahead of more auctions this week, with the Treasury Department set to sell $82 billion of Treasury notes and bonds.

The 10-year yield is a key benchmark for mortgage rates and other consumer and corporate lending.

“So, what does this mean?” you say. I’m so glad you asked…

Someone can buy a U.S. treasury bond, for something like $1,000. Let’s say you buy one that matures in 10 years. Over the life of the bond you will receive interest on your “loan” that is set when you first purchase it. Now along the way you can decide to sell the bond to someone else.

If today’s interest rates are exactly what they were when you bought the bond, then the fair price for the bond is $1,000.  However, if interest rates have gone up, then your bond is delivering less interest than someone could get by buying a new bond at the higher rates. So, to sell the bond you need to reduce or discount the price. Someone might be willing to pay $950 for your bond, receive lower interest for the remaining years, and then get the original $1,000 back.

If today’s interest rates are lower, you’ve got an attractive bond to sell. The new owner can earn higher interest than they otherwise could and should be willing to pay a premium for the bond – perhaps something like $1,050.

The result is that the price of bonds, on this secondary market, are inversely related to the interest rate. As rates rise, the price of bonds fall, and vice versa.

And when the U.S. Government needs to sell bonds in the primary market it must offer an interest rate that will attract investors. The news item from the WSJ suggests that interest rates are rising for a couple of reasons. First, with stronger economic results, investors have been returning to the equities market (i.e. stocks), leaving the relative safety and lower yields of the bond market. So demand for U.S. bonds is lower. On the supply side the U.S. Government is accelerating its debt, and needs to sell more and more bonds to cover our deficit. So, decreased demand and increased supply means lower prices, and in this case means the starting interest rate needs to rise.

The other piece not mentioned here, but swirling around nonetheless, is growing concern about U.S. bonds and their credit worthiness. U.S. Treasury bonds have historically had the highest credit rating, reflecting, in essence, risk free investments. There have been mutterings and informal warnings from a couple of credit rating agencies, that they may downgrade U.S. treasury bonds. Were that to happen, then the Fed/Treasury would have to offer higher interest rates on those bonds – to compensate for slightly higher risk.