How Treasury Yields Impact the Stock Market?

Todays is the 5th of March 2021. The Nasdaq Composite closed at 12,723.47 yesterday well off its highs of 14,095.47 on the 12th of Feb 2021. The market is down 9.73% since its peak on the 12th of Feb. Stock market reversals cause panic which is why it’s important to understand what drives the markets.

These series of articles are an attempt to answer this question. If you know of other factors that impact the stock market or have an article to share on how stock market is impacted by events around it, we would be happy to hear from you at invest@thetwigg.com. These articles are simple in nature and at a very summary level highlighting the impact. For details on how some of the concepts work, you should refer to some of the sources cited in the article.

In this article, we will focus on how the Treasury yield impacts the stock market. “US department of treasury” https://home.treasury.gov/about/general-information/role-of-the-treasury is the entity responsible for maintaining a strong US economy while protecting the integrity of the financial system. This enables US to be an influential participant in the global economy.

The US department of treasury uses financial instruments or products such as treasury bills, treasury notes and bonds to borrow money. This article on investopedia https://www.investopedia.com/updates/usa-national-debt/ explains really well the concept of US national debt and the reasons why treasury issues these instruments to borrow money.

Now when the creditors lend money to the US treasury, they expect a return on their original money borrowed. The creditors (who lend money), loan their money by buying the treasury notes, bills and bonds with an expected rate of return.

This rate of return is the treasury yield for periods of time for which the money has been loaned to the treasury. This is the return that the US government pays to borrow money, i.e the amount the investors/creditors expect to receive for letting the gift borrow their money.

Recap:

1. US depart of treasury sells bonds, bills and notes to borrow money. https://www.investopedia.com/ask/answers/difference-between-bills-notes-and-bonds/

2. investors earn money by buying these instruments. To buy these instruments, investors have to deposit money (loan/principal) with a promised return of their principal back along with an interest after a period of time.

3. Each of these instruments are for a defined period of time which is when the principal is returned along with interest.

4. The interest that is paid/promised to be paid over the principal expressed as percentage is the treasury yield.

There is an excellent article in the balance which explains how the treasury yields impact the economy: https://www.thebalance.com/treasury-yields-3305741

So how does the treasury yields work? Most of us would have had experience with a Post Office Savings Bond which are bonds issued to a single owner and is not transferable.

In case of treasury bonds, the bonds can be bought and sold. The bonds have a face value which is the original price of the bond when issued, market price at which the bonds could be bought and sold in secondary markets (between holders and buyers of bonds),I.e not directly from the treasury.

The bonds have a fixed rate of return against the face value for a defined time period for which it is issued. This interest is paid over the period of the bond with the principal paid back at the end of the term. So, a holder of the bond for the entire period would have received the interest and the principal at the end of the term.

What you should keep in mind is that this rate of return against the face value is not yield but the interest US govt is willing to pay for borrowing money defined as a percentage against the face value. Remember: interest being paid is against the face value.

The yield (treasury yield) is the amount the creditor is expected to make against the price he pays (market price of the bond) which could be higher of lower than the face value of the bond. This is an essential concept in trying to understand how treasury yields work and impacts the economy. So remember, yields are expected rates of return against the money paid to big a bond over the defined time period of the bond.

Also worth noting is that treasury bonds, bills and notes are considered safe investments as they are backed by the US govt which has the ability to tax to fund its borrowing capacity.

Let’s look at some scenarios here:

Economy is in crisis. Investors will rush to safer investments. Demand for treasury bonds will increase. The price at which the treasury bonds are sold will increase. The rate of interest promised by the US treasury for the period of the bond is still the same. So, the borrower is having to pay more for the same interest on the bond. That means his yield has reduced (money being revived against the amount being paid expressed in percentage). Yield percentage reduces.

Investors are optimistic about the economy. There is less demand for treasury bills, notes and bonds. Investors are focussed on riskier investments. Demand for long treasury instruments is low. Price at which these are sold will reduce. Treasury yield will increase as same interest is being paid for a lower market price. Yield percentage increases.

Now, what’s happening now. Stock markets are impacted by various causes, various dynamics at play. It’s like emotions which are various and innumerable. But we r able to discern the mood from it still. Currently, the treasury yield is increasing with greater positivity around the economic recovery. With greater yields from safer treasury instruments, the stock markets is taking a breather or sort of reset from its highs.

In conclusion, treasury yields impact the stocks markets in reverse with all other factors remaining constant.

1. A higher treasury yield will reduce demand for stocks

2. A lower treasury yield will increase stock market demand raising the stock market levels.