Apr. 20, 20219 min read

Are Treasury Yields a Secret Stock Market Barometer?

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Written by Staff

Treasury yields and interest rates — two buzz words for old-school investors. And although retail traders may not be interested in the bond market, understanding how yields impact Wall Street could help your trading decisions. 

What Is a Treasury Yield?

Simply put, a Treasury yield is the amount of interest you earn on a Treasury security — bills, notes, or bonds — over a set time period. When an individual purchases a Treasury security they’re ultimately giving the government a loan.

We’ll use the example of a car loan. When you take out an auto loan from a bank it comes with a set interest rate. That interest is what the bank earns on top of the principal they provided you to purchase the car.  Instead of an interest rate, Treasury securities have a yield — let’s say 2% — that the buyer will earn on top of the principal they provided to the government. That 2% return is paid out on a set schedule for the term of the security and the buyer will be paid back their full principal amount when the term expires.

The 10-year yield is used as the benchmark in the U.S. for other interest rates like mortgages and car loans, so that’s what we’ll focus on for the rest of this article.

What Causes Treasury Yields to Change?

What causes Treasury yields to move up and down is much like the price of anything else — supply and demand. When there’s a lot of demand for Treasuries, the price of the security rises and the yield falls. When there’s lower demand in the market, the price of the security falls and the yield rises as the government attempts to attract buyers.

Those yields are also impacted by the Federal Funds Rate, which is set by the U.S. Federal Reserve. When the Fed lowers interest rates, yields typically fall. On the flip side, when yields rise the Fed usually has to raise interest rates.

Why Has There Been Such a Focus on Treasury Yields Amid the Pandemic? 

When there’s uncertainty about the economy, investors flee to Treasuries. Those securities are seen as safer investments than the stock market since they’re backed by the government. As COVID-19 took hold in early March 2020, the 10-year Treasury yield hit all-time record lows as a historic surge of investors bought the notes and pulled out of the stock market in fear of a crash. 

And that crash did come. On March 16, 2020 the DJIA saw its worst one-day drop since “Black Monday” in the Great Recession, the NASDAQ logged its single worst daily percentage drop in history and the S&P 500 saw its third worst drop on record. By March 23, the S&P 500 was officially in a bear market — falling 20% from its previous record high on February 19, 2020.

The Federal Reserve also stepped in to “support the smooth functioning of markets”. On March 15, 2020, the Central Bank vowed to purchase at least $500 billion in Treasury securities and $200 billion in government-backed mortgage securities. That move ultimately pushed more money into circulation by providing banks with more cash. The Fed also set the Federal Funds Rate at a range of 0-0.25% “to support the flow of credit to households and businesses”.

The Fed has kept this program running throughout the pandemic, purchasing hundreds of billions of dollars in securities every month to push more cash into circulation.

The Stock Market Quickly Bounced Back From the Pandemic Crash

The bear market of 2020 was the shortest on record. The S&P 500 set a new closing record on August 23, 2020 and was officially declared a bull market. That rise came as tech stocks saw a meteoric climb with investors pouring into companies like Tesla (TSLA), Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), and Alphabet (GOOGL, GOOG).

A whole new sector of stocks was born out of the pandemic as well. So-called “work-from-home” stocks saw a surge in investment as companies sent their employees home and invested in technology to keep them working amid the pandemic. The biggest of those winners was Zoom Communications (ZM) as nearly every company across the country turned to the video conferencing software to continue working.

Other big beneficiaries from the pandemic-era investment boom were telehealth service Teladoc Health (TDOC), communications software company Slack Technologies (WORK), cybersecurity firm CrowdStrike Holdings (CRWD), e-signature leader DocuSign (DOCU), and at-home fitness giant Peloton Interactive (PTON).

A Much Riskier Breed of Trader Was Born Amid the Pandemic

2020 saw a major increase in retail investors and they upped the game on how much risk they were willing to take. Instead of making long-term growth investments, these day traders were looking for where they could make money fast

That boom was bolstered by the government sending out stimulus checks — essentially free money they could turn into a big profit if they picked the right stock. And the pinnacle of these investors was GameStop (GME).

Retail Investors Take On Hedge Funds

This story has been told a million times but here’s a quick summary…

In January of 2021, users on the subreddit r/WallStreetBets started talking about GameStop (GME). Users had noticed the enormous short interest in the stock and saw an opportunity to make money. At that point, about 140% of the public float — which is the number of shares sold to the public — was being shorted by hedge funds. That meant more than 100% of the shares available to be purchased were being shorted. 

WSB users saw an opportunity for a short squeeze and started feverishly buying up the stock. By January 28, 2021, GME hit an all-time intraday high of $483. A similar short squeeze was launched on AMC stock and controversy arose with platforms halting trades of GME and AMC, but we won’t get into that. 

The so-called GameStop saga was a signal to old-school investors that something was changing in the market and these retail investors were here to stay. 

Market Pulls Back in Early 2021 as Treasury Yields Rise

Remember earlier when we discussed how Treasury yields rise and fall with supply and demand? As the future of the economy started looking better in early 2021, the rush of activity in Treasury securities began to slow and yields began to rise. 

In March 2021 the yield on the 10-year Treasury note spiked to 1.77% and that spooked Wall Street. Remember, rising yields typically = higher interest rates. But even as yields rose, the Fed said it was committed to the new policy it adopted amid the pandemic.

The Central Bank has vowed to keep base interest rates near-zero through 2023, prioritizing recovery in the labor market over inflation pressures. But Wall St feared the spike in Treasury yields along with rising inflation might force the bank to hike rates earlier than promised. 

In recent weeks Treasury yields have calmed down, actually falling in mid-April even as the government released strong economic data. Traditionally there would be a shift out of Treasuries as the economy recovers, which would drive yields up. But many experts believe strong backward-looking data — like surging retail sales in March and improving jobless claims — is already priced in for bond investors.

Economic growth is expected to peak in the second quarter of 2021 as businesses continue to reopen and the U.S. ramps up vaccine distribution. Growth will likely remain strong in the third quarter, but down from the surge in Q2. 

That scenario is good for both bonds and stocks. Slower growth boosts the bond market while lower interest rates and good economic data bump up stocks.

Wall Street Is Still Worried About Interest Rates

The possibility of rising interest rates as the economy recovers could be the biggest threat to the stock market. A recent survey by CNBC found that is the biggest concern for investors. 62% of respondents to that survey said they expect the 10-year Treasury yield will be above 2% by the end of 2021. And although the Fed has said they don’t plan to hike rates, such a sharp increase in yields may give them no choice. 

With economic growth returning to normal levels, the trend on Wall St will naturally shift back into growth stocks and out of the big tech and “work-from-home” stocks that shined so bright in 2020. That might not be all bad for smaller traders. Such a shift could create a “discount” scenario for a company one might have missed out on before — giving them the chance to buy a long position at a cheaper price to create a safety net for any risky day-to-day trades.

2020 was a volatile year for markets, one that saw a lot of new retail traders make a lot of money really quickly. But as the economy gets back to normal, market activity will also shift back to normal. Learning now what normal market function looks like may help you make better decisions in the future. 

Image: William Potter/Shutterstock