Bond Yield Bonanza: Why is everybody talking about bond yields, what the hell are they talking about, and why should I care?
Yahoo! Finance: “Stocks and bonds sold off after Federal Reserve Chairman Jerome Powell underwhelmed markets by refraining from pushing back more forcefully against the recent spike in Treasury yields.”
CNBC: “U.S. stocks fell sharply on Thursday after Federal Reserve Chair Jerome Powell failed to reassure investors that the central bank would keep surging bond yields and inflation expectations in check.”
Ummm…so what does this mean…in English?
Translation: Bond yields are rising. This indicates the market expects inflation to increase. The U.S. central bank is taking a hands-off approach. People got spooked so they sold lots of stocks. Explanation follows.
Topic 1: What are bonds and bond yields?
Topic 2: Why are bond yields rising?
Topic 3: I always get inflation and interest rates mixed up…please help.
Topic 4: Why the heck do rising bond yields matter?
What are bonds and bond yields?
A bond is an IOU: a fixed rate loan for a predetermined duration. For example, let’s imagine a $100 loan that charges 3% annual interest, paid annually, with the principal due after 20 years. The interest is called the “yield” because it represents how much the bond…yields. (More precisely, the yield at the time of issuance is called the “coupon,” but we will ignore that.)
Bonds are issued by governments — federal, state, and municipal — and corporations to raise funds for spending. Let’s just focus on a certain category of government bonds for now, the ones everybody is talking about in the news. These bonds are called “Treasuries” because they are issued by the U.S. Treasury, a department of the federal government. Corporations and institutions buy them to earn interest. You might be familiar with “war bonds” — bonds citizens purchased during World War II to help fund the war effort.
Treasuries are important because (1) the government issues a LOT of them, so they make up a good chunk of the overall bond market, and (2) they are backed by the full-faith-and-credit of the U.S. government. Because the U.S. government is supported by the American economy, and financial and legal systems, Treasuries enjoy exalted status, serving as a benchmark for global markets. In contrast, bonds issued by less credible governments— say, El Salvador — are less coveted because those governments are riskier creditors. Accordingly, those bonds must offer higher interest rates (yield) to attract lenders.
Let’s use an example. TechCorp, a large technology company, has some cash sitting around and is looking to generate a return on it. So it buys a $100 Treasury bond with a yield of 3% and 20-year maturity. In exchange for lending the government $100, TechCorp will earn a $3 annual yield for as long as it holds the bond. If TechCorp holds the bond until maturity (here, 20 years), it will then be paid back the $100 by the government. Simple enough.
However, when you hear about the bond market in the news, you are almost always hearing about the SECONDARY market. This is a public resale market, not the primary issuance market. In the secondary market, bondholders sell bonds to other parties.
In our example, let’s say one year passes and the economy slumps. With stocks down, TechCorp’s 3% yielding bond looks more attractive to buyers than it did a year prior. PharmaCorp comes along and buys TechCorp’s Treasury bond for $102 on the secondary market. Remember that TechCorp paid $100 for the Treasury, so TechCorp makes a $2 profit on the sale, in addition to keeping the $3 interest earned in year one.
Importantly, the Treasury bond continues to generate the same annual interest of $3, per the terms at issuance. Because PharmaCorp paid $102 for the bond, however, the yield is no longer 3%. Instead, it is $3 divided by $102 (annual yield payment divided by purchase price), which equals 2.94%. This calculation of annual interest divided by purchase price is referred to as the “current yield,” meaning how much it currently yields. Kinda makes sense, right?[i]
Let’s say another year passes, the stock market is now soaring and bonds are consequently less appealing to investors. (This has been the case in the real world for the past few years). AgroCorp comes along and offers PharmaCorp $98 for the Treasury bond. PharmaCorp, feeling some intense stock market FOMO, takes the loss on the Treasury (which it had purchased for $102) so that it can put the money in the stock market instead. PharmaCorp thus loses $4 ($102–$98) on the face value of the bond. Remember that PharmaCorp collected $3 in interest for the year it held the bond, so its net loss is $1. To AgroCorp, the bond’s current yield is $3 divided by $98, which equals 3.06%. And there you have it — the bond yield increased from 2.94% to 3.06%!
Bonds can be tricky to understand at first because of the inverse relationship between the current price of the bond (what it sells for on the secondary market) and its current yield. When price falls, yield rises by definition, and vice versa. This is just a simple mathematical relationship. When people say “bond yields are rising,” remember that they are referring to the YIELDS (that is what they said, after all), not to be confused with PRICES. This can be confusing because you hear the word “rising” or “increasing” and think the bonds must be getting more expensive. But, in fact, the opposite is true.
Why are bond yields rising?
Let’s apply what we have learned to the real world. Bond YIELDS have been rising, which means the PRICES of those bonds have been falling. In other words, bonds are becoming cheaper.
Why are bonds becoming cheaper? Supply and demand. Fewer people want them at their current yields. Why is this? Now is where it gets interesting.
The primary explanation is that the market expects inflation to increase. Ughh…inflation, that seemingly simple yet elusive concept. To begin with, you must not confuse inflation with interest. Both involve money going up, start with the letters “in”, and consist of three syllables (depending on how you pronounce “interest”). And, they are interrelated. But they are not the same thing, and you must keep them separate in your mind.
Inflation can take different forms, but we will consider it in the ordinary sense: a general increase in the cost of goods and services. Remember how your grandpa paid just a nickel for an ice cream back in the day? That is what we are talking about.
Why does the market expect inflation to increase?
First, the U.S. government, among others, has injected a whole lot of money into the economy, functionally printing money out of thin air. (Yes, that is actually how the economy works.) In 2020, the supply of broad money increased about 20 percent. Broad money is that which actually makes its way into the real economy, rather than being stuck in a bank vault as a reserve. In other words, 20 percent more dollars were created into existence in the last year.
The market expects this money to make its way into the cost of goods and services. Think of the stimulus checks people have received and will probably continue to receive. People will spend those dollars, and the increased demand for goods and services will presumably drive up prices. Simple supply and demand.
This brings us to the second explanation for inflation expectations: the “pent-up demand” thesis. People have been saving at high rates during COVID. Despite high unemployment, average household income has increased thanks to government welfare. People have also cut expenses, almost certainly because of the psychological effect of economic uncertainty, and also because it is logistically challenging to order that $7 half-caff skinny mocha-frappiato breve veinte with whipped cream and hazelnut syrup on the daily when you are stuck at home all the time.
With the market anticipating higher inflation, current bonds yields, which are between 0% and 2% depending on the duration, look almost as unappetizing as the drinks pictured here. If inflation, which is about 1.4% at time of writing, increases to just a modest 2%, then these bonds would not even keep up with inflation. They would lose real value over time, even as they generate nominal returns. Consequently, buyers are now looking at those meager bond yields and saying, “Screw that, either you sell me those bonds on the cheap or I’ll put my money elsewhere.” This pushes the PRICES of bonds lower. And what happens when bonds PRICES fall? Say it with me now…Yields RISE.
I always get inflation and interest rates mixed up…please help.
To summarize what we have covered so far, rising bond yields (i.e. falling bond prices) signal that the market anticipates an increase in inflation, driven by money-printing-stimulus and the expected release of pent-up demand when the economy re-opens.
Inflation has not been a real problem for decades, so it is somewhat unfamiliar to many of us. But inflation has been a more salient concern recently, thanks to unprecedented levels of government stimulus and the fact that we just went through a global pandemic. We are in uncharted territory and nobody knows WTF is going on.
Introduce the Federal Reserve Bank (“the Fed”). The Fed is America’s central bank: the granddaddy of all banks. It is a quasi-governmental institution designed to be independent from the rest of government.[ii] In theory, this prevents politics from interfering with economic policy, certain Tweets notwithstanding:
The Fed has a dual mandate: (1) to promote full employment and (2) to keep overall prices of goods and services stable i.e. manage inflation. The Fed’s primary tool to manage the economy has traditionally been the ability to manipulate interest rates. (Remember high school economics? This is called “monetary” policy.) REMINDER: interest rates and inflation are different concepts entirely, despite being interrelated.
“So wait,” you interject. “Are you saying the Fed sets the interest rate on my car loan?” Well, yeah…kinda…sorta.
The Fed controls one specific type of interest rate: the “overnight lending rate” a.k.a. the “federal funds rate.” This is the rate that commercial banks charge each other to borrow money. Let’s say Bank of America needs some cash to fund loans to commercial customers, so the bank borrows some money from Wells Fargo. This loan would be subject to the federal funds rate. Consequently, Bank of America sets interest rates on the commercial loans based on the federal funds rate, presumably at a higher rate, because believe it or not, even banks have to generate a profit. (Or not…and just ask for a bail-out.)
Because the federal funds rate ripples through interest rates economy-wide, including rates for car loans, mortgages, business loans, and credit cards, it is the granddaddy of all interest rates. (This is one major reason why the Fed is the granddaddy of all banks.)
You know how people say, “Now is a great time to refinance your mortgage. Interest rates are low”? Well, mortgage rates are largely determined by the federal funds rate. So yeah, this stuff actually matters to real people. Those who had a mortgage in the 1970s or early 1980s will remember that interest rates were 10%–20%! In contrast, mortgage rates have been below 5% since the 2008 economic crisis, making home ownership more accessible, not to mention other forms of commercial and consumer debt. This keeps people happy, especially the powerful single-family homeowner lobby. (How convenient.)
Because the federal funds rate drives interest rates economy-wide, it provides the Fed a powerful tool to manage the overall level of economic activity. For instance, if you faced a 15% mortgage interest rate, you might wait to buy that house. But at 2% interest, you will buy right now. The same logic goes for taking out a loan to start a business or buying a car on credit. Because our economy is so debt-driven, interest rates are extremely important.
This ability to manage the level of economic activity allows the Fed to manage inflation, because increased economic activity drives inflation upward and decreased economic activity is deflationary. The Fed uses the federal funds rate like a gas pedal when it wants to give the economy a boost (like right now), and like a brake pedal when the economy overheats and risks high inflation. Gas pedal = lower rates. Brake pedal = higher rates.
In “normal” times, whatever that means, the Fed’s two mandates — full-employment and low inflation — do not usually conflict. According to economic orthodoxy, inflation typically occurs when the economy is strong and employment is high. In this scenario, the Fed can afford to step on the brakes without hurting employment levels too much. Conversely, when the economy is struggling and employment is low, we expect inflation to be low, allowing the Fed to pump the gas to boost the economy without fearing inflation getting out of hand.
Which FINALLY brings us to…
Why the heck do rising bond yields matter?
As discussed above, rising bond yields signal that the market is expecting increased inflation. This is not very surprising, with another round of government stimulus on the way and vaccines being rolled out.
Rising bond yields present a challenge to the Fed. Should the Fed step on the brakes by increasing the federal funds rate, at risk of prematurely stalling the recovery and the return of full employment? Or should it keep the federal funds rate low, which would promote jobs by letting the economy run hot, but at risk of higher inflation?
The Fed’s dual mandate is thus at odds with itself, because we are in a strange situation where unemployment looks like The Great Depression while other parts of the economy — namely the stock market — soar. (Something smells fishy here). Thus far, the Fed has prioritized full employment above inflation concerns, with Chairman Jerome Powell recently saying the Fed will be “patient” with respect to increasing the federal funds rate.
Let’s talk about how this affects markets. The yield on the 10-year Treasury has increased from 0.93% to 1.54% in the past two months. It might not seem like much, but it matters. Meanwhile, the stock market has fallen about 4% over the past three weeks.
The stock market has fallen for at least three reasons. First, higher bond yields make bonds a more attractive investment — because they yield more! Therefore, some money that was previously invested in stocks has moved to bonds, decreasing demand for stocks and consequently stock values.
Second, the fall in stock values might reflect concerns about the pernicious effects of inflation on corporate profits. If corporations face a rising cost of goods and services, their profits might suffer.
More importantly, however, is the effect of inflation on corporate financing. Corporations often borrow to expand their business. If they want to issue their own corporate bonds to raise funds, the yield on those bonds will have to compete with higher yields in the broader bond market. This makes borrowing more expensive. Additionally, if inflation causes the Fed to increase the federal funds rate, banks will then increase interest rates on loans to corporations.
The economic calculus facing corporations is like that of the interested home buyer. When interest rates are low, just go hog-wild. Why not? It’s cheap. But when interest rates are higher, one must be more restrained.
Higher interest rates particularly hurt tech companies, which tend to be more dependent on debt-financing than other companies, which are typically more self-sufficient. Tesla is a good example. The company runs on debt and equity; it has never earned a profit, not counting tax credits. Thus, Tesla and companies like it are especially vulnerable to higher interest rates.
I speculate that tech stocks are getting hit hard also because they were highly valued to begin with. Tech stocks soared through 2020, so maybe this is just them coming back down to earth. Hopefully, they do not end up like the SN10.
How do rising bond yields affect Bitcoin? On one hand, Bitcoin has done very well in a low bond yield environment. This could be because cheap debt has allowed people to speculate on Bitcoin more easily. It might also be because the combination of unattractive bond yields and a highly priced stock market left investors looking for other places to invest. In a higher bond yield environment, those investors might leave Bitcoin for bonds, or for stocks that are more affordable than they were previously. This would drive Bitcoin’s price down, all else being equal.
On the other hand, the expectation of increased inflation — as signaled by higher bond yields — feeds into Bitcoin’s “digital gold” narrative as an inflation hedge. This would increase Bitcoin’s appeal and drive up the price.
We are in an interesting spot. The bond market seems to anticipate inflation. At the same time, the Fed is acting like inflation is not a real risk. Who is right?
For Bitcoiners, this question should just be noise. If you do not yet hold Bitcoin, but are interested in it, just buy some and hold on for dear life. Leave the speculation to the speculators.
The End.
[i] Another type of yield is “yield to maturity,” a more complex calculation that takes into account the value of time (in this case, the 19 remaining years until maturity), similar to internal rate of return. For our purposes, let’s just stick with current yield.
[ii] A previous version of this story referred to the Fed as a government institution. A few readers pointed out that is inaccurate. The Fed was created through government action, but operates as a corporation. It enjoys certain unique legal privileges, and is considered a government institution in certain domains of law, and a private corporation in others. So let’s just call it quasi-governmental. Thank you to those diligent readers.
Thanks to Lyn Alden for her consistently phenomenal writings on macroeconomics. I have learned a ton from her. www.lynalden.com
