How Yield Curve Impacts Investment
We are on the precipice of a likely federal Funds rate increase before the end of 2015. This is no surprise as the Fed has kept the federal funds rate at just about zero for many years as a way to help the flailing economy. It has worked, to some extent anyway, and now with huge gyrations in the international market, with China’s crash and a return to depths of fiscal-recovery impossibility for Greece, our country has got to make moves to raise rates and normalize our economy. The federal funds rate is currently at 0.13 percent. Just to pull this into perspective regarding how this affects the U.S. treasury rates, the federal funds rate is the rate that banks charge each other to borrow excess reserves. Those funds are then used to trade in the overnight, but just like renting a car, you pay a small fee to use the vehicle with the idea you will bring it back as it was when you picked it up. The same applies to funds in this case. The fee to borrow excess reserves is just that. The money has to be returned in the morning. One of the main places money is traded in the overnight markets is in bonds.
Our treasury market in the United States is a barometer of fiscal for the entire planet. More to this point, our regulators monitor closely what goes on in this market. In fact, regulators are going to issue findings on a review of bond market conditions this coming week. They are also going to identify if the government is culpable in matters relating to complaints about trading in this market. The reason being is their activities to stem the troubles emanating from the financial crisis in 2008 may have caused large block trade problems that they are currently receiving reports about. More to this point, there was an event in the treasury bond market in late 2014 that was called a “flash crash.” Yields plummeted and quickly recovered, but this also points to a problem in being able to effectively trade huge blocks of treasuries quickly. The reason all of this is an issue is because the U.S. Treasury market is larger than it has ever been, and just a decade ago it was 66% smaller than it is now. The concern is that if it is taking too long to trade large blocks, this could lead to instability when the fed raises the federal funds rate later this year. This is indeed a big concern especially with the current global fiscal issues led by Greece, and to a lesser extent, China.
Currently, as of market close on July 10, 2015, the 10 year treasury yield is at 2.42. The 30 year treasury rate is at 3.20. Unlike corporate bonds, treasury bonds have theoretically zero-risk of default, as they are tied to the full faith and credit of the United States government. That being said, when federal funds rates go up, bond yields will go down. Corporate bonds have credit risk premium that allows for a little bit of cushioning when rates go up. Treasuries do not have that, which is also why regulators are concerned with block trades running smoothly as they anticipate increased activity going into the federal funds rate increase. The ten year treasury yield are invariably about 50% less than the 30-year bond rates, and notes, which are issued in 2, 3, 5 and 10-year terms, are always lower than the 10 year treasury rate. The 10 year bond is a popular investment option as treasuries go, especially for those who understand how to use federal fund moves to their advantage. That being said, all treasuries are considered extremely safe places to put money; it all depends on how long you want to invest for.
All of these instruments are a form of debt that the U.S. government issues as a way to finance running the federal government, and to leverage treasury rates to settle on maturing issues. Countries the world-over buy our bonds in large blocks, and our treasury market is very robust for this reason. It is our credit rating in the international markets that makes giving the U.S. a loan, in the form of buying a bond, such a smart investment; it is a very safe bet they will get their money back. In fact, China buys copious amounts of U.S. debt in the open market every day. Where the financial loss takes place is having to sell a bond with a yield higher than current rates. Interest is being given up and dollars are being lost if forced to sell at a discount. More to this point, it is no accident the U.S. is making it less appealing to sell our bonds at this moment. China and Greece have had robust markets in the past, and although they are both expected to recover, with more faith in China recovering more quickly than Greece might, we preserve our markets by making moves that protect us.
Rate-raising at this point is because our government manages our markets aggressively. You may not like the way they look, or perhaps what they say, but our Federal Reserve, and our current chairwoman Janet Yellen, are very powerful people. Although their remarks and moves may not always be coveted, the United States has a very strong financial market, and the treasury market is absolutely a big part of that strength. A raising of the federal funds rate will serve to discourage treasury bond sales, albeit temporarily. Data in the coming week will tell the Fed all they need to know about tightening the credit markets, and precisely when they should act. For individuals, U.S. treasury rates will likely have little impact, and buying treasuries today, or in December is not going to affect individual investors all that much. Block trades are the hallmark of the treasury market, and with rates about to rise, banks and countries that own millions of dollars in our treasuries will be affected. Trades will take place, but it is far better to lose a bit on a U.S. treasury than put your money in a more precarious place where losses could be much more. For this reason, our treasury market remains very stable no matter what prevailing rates are.