Author: Aman Murba Research Analyst
US 10-Year Treasury Yield Hits 7-Year High
The 10-Year Treasury Yield is the interest rate the US government pays on its debt obligations. Amid reports detailing strong retail figures over the last couple months, the 10-year treasury yield briefly topped 3.1% on Wednesday May 16th. The reports signaled that the economy has enough momentum to grow at a steady pace. This yield increase followed after a bond market sell-off on Tuesday May 15th. With record low unemployment rates, traders pay close attention to retail sales and mean hourly earnings to predict inflationary pressures.1 This is because as wages increase, employers must increase prices of their goods and services to maintain a steady level of corporate profits. However, this has a circular effect since as the cost of goods increases, higher wages are needed to compensate. This is formally known as wage push inflation.
On Tuesday, the two-year yield touched its peak-level since 2008 at 2.589% and the 30-year yield hit a high of 3.22% which is the highest since April 26, 2018. Long-term yields are typically higher than short term yields because the long-term horizon makes it more likely that a rise in interest rates will result in a larger capital loss. Thus, investors want to be compensated for their level of risk accordingly.
Investors pay significant attention to the 10-year yield as it reflects rates in financial instruments such as mortgages. Moreover, the 10-year yield is particularly significant because when confidence is high, investors believe that they’re able to find better investments for their money and don’t feel the need to play it safe.
However, lower investor confidence results in an increase in price as there is an increased demand from investors for a safe investment. This generally results in a decrease in bond yields. When other countries are impacted by geopolitical situations, the US bond demand rises due to foreign investors thereby lowering yields.
10 year yields are followed very closely. It is crucial to have knowledge of the historical pattern in order to understand how today’s compare. In general, rates are not widely dispersed. However, when rates change by more than 1% over a short period of time, the change can redefine the economic landscape. Jamie Dimon, CEO of JP Morgan sees the 10-year yield eventually approaching 4%.
In terms of consumers, a higher 10-year yield affects 15-year mortgage and banks and other lenders charge more interest for mortgages. This makes housing less affordable, thus depressing the housing market. This can result in slower GDP growth.
The S&P 500 Index tracks the return on 500 large companies listed on the NYSE and NASDAQ. Investors and economists track the difference between the S&P 500 to compare returns on equities and bonds. Currently, the spread between the S&P 500 Index yield and that of the 10-year Treasury is approaching the lowest levels in eight years. Many investors consider this a sign of worry in a time where rumors of trade wars flood media outlets and signs of slowed global growth emerge.
In terms of corporate credit, companies that are least creditworthy have benefitted from low benchmark yields. However, if borrowing costs rise, debt becomes more expensive which may pose a risk to corporations with high leverage.
The US dollar will likely strengthen against most other major currencies according to Neil Dutta of Renaissance Macro Research LLC. He attributes the increase in real yields and relative increase in dollar value to the US economy’s brighter outlook compared to the rest of the world.
An increase in interest rates decreases the present value of FCF’s of a leveraged firm, all other variables held equal. This is because an increase in interest rates generally increases the cost of debt, therefore increasing the WACC.
The above information does not constitute the provision of investment, legal or tax advice. Any views expressed reflect the current views of the authors, which do not necessarily correspond to the opinions of University of Waterloo Finance Association (“UWFA”). Opinions expressed may change without notice. Opinions expressed may differ from views set out in other documents, including research, published by UWFA. The above information is provided for informational purposes only and without any obligation, whether contractual or otherwise. No warranty or representation is made as to the correctness, completeness and accuracy of the information given or the assessments made.