Government debt has nothing to do with the valuation of stocks…or does it? We look at why investors are worried about Treasury yields.
What are Treasury notes?
Treasury notes are securities that pay a fixed interest rate every six months until the security matures and the Treasury repays the par value. For example:
The U.S. government issues a $100 note with a yield of 5% for ten years. The Treasury pays $2.5 every six months, equaling $5 each year. Upon maturity, the Treasury pays the final $2.5 installment and the original $100 back to the holders of these notes. Over the life of this debt, the value of the bond fluctuates. If the face value decreases, the yield increases as the interest payments remain fixed and vice versa.
How does the Treasury yield impact stocks?
When calculating the intrinsic value of a share, investors include the risk-free rate of return. This is the interest rate an investor can expect to earn on an investment that involves no risk, such as Treasury notes. Treasuries are backed by the U.S. government, which has never intentionally defaulted on its debt repayments, whereas bankruptcies are relatively common. When the yield on a bond rises, the required return from a riskier investment also increases, such as stocks.
However, in a downturn, these risky investments are unlikely to meet this criterion, and so get shunned by investors as they can earn a better return relative to the risk involved by investing in government debt. However, this eventually increases the value of the bonds, lowering yields and making stocks more attractive.
There is not just one length of Treasury note. They come in varying maturities, such as two-year, three-year, five-year, seven-year, and ten-year, to name a few. Treasury notes with longer maturities tend to pay higher yields than short-term ones. This is because it is harder to forecast how well the economy will be doing or interest rate levels in ten years than in two years.
Why are U.S. Treasuries making headlines?
Yields on the 10-year U.S. government bonds have recently slumped below those of the two-year notes for the third time this year. Inversions like this have preceded every U.S recession over the past 50 years — generally within the following year or two. This inversion occurs when investor sentiment falls, and they sell the shorter-term notes to buy the longer-term bonds as these become safer assets. This acts as a warning signal for an economic downturn
Equity investors, who are frightened by the potential of a nearby downturn, have pulled out of their risky equity investments and are loading up on assets such as cash, gold, and bonds. Last month the U.S. manufacturing sector experienced declines in new orders and employment, which raises concerns about the strength of the U.S. economy. Analysts also anticipate a decline in economic output by the end of the second quarter, further increasing the likelihood of a recession — defined as two consecutive quarters of contraction. This has led to investors increasing their holdings of 10-year Treasury bonds and lowering their exposure to equities.