How Bond Yields impact an economy

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Summary

• US 10-year Treasury yield crossed the 1.6% mark and hit a one-year high last week following vaccine rollout and Biden government’s anticipated stimulus package.
• Bond yields have an impact on the economy, as is currently visible; however, they are also affected by changes to the economy.
• Economic slowdowns can be beneficial for Treasury yields unlike other investment channels.

The return on investment on the US government’s debt obligation, known as the US treasury 10-year bond yield, crossed 1.5% mark on March 4 after Federal Chairman Jerome Powell indicated a temporary rise in inflation. Notably, the US treasury 10-year bond yield hit a one-year high last week, crossing 1.6% on February 25 on the back of vaccine rollout and Biden government’s anticipated stimulus package.

The return on investment on the 10-year Australian bonds also closed at 1.855% on March 4, though at present the yield is seen giving a return of 1.840% at 12:54 PM AEDT on March 5. 

The treasury yields were expected to go up for a long while, however, the economic slowdown delayed the surge. These changes in bond yields have subsequent impacts on the economy. The same stands true vice versa, i.e, economic changes too impact bond yields.

The US bond market saw an uptick in the anticipation of USD2 trillion stimulus package by the Biden government. Additionally, the vaccine rollout further enhanced these expectations. As a result, real yields started to improve too which further pronounced the surge.

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Here’s a look at how such fluctuations in bond yields can impact the economy:

Bond Yields and Bond Prices

Before understanding the relationship between treasury yields and the economy, it is important to understand the relationship between bond prices and yields offered by these bonds. Treasury bond yield and prices are both determined through demand and supply of Treasury bills (T-Bill). As bond prices increase, its yield declines and vice versa.

For two different bonds falling in the similar category, coupon payments must be same. Thus, if one bond offers higher yield tomorrow than that offered by another bond today then the prices must adjust on the former to make the coupon payments equal.

Bond yield is calculated by dividing the coupon payment by bond price. Therefore, any changes in bond prices would impact the yield inversely.

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Bond Yields and the Economy

Just like traditional measure of mapping economic growth, yields on T-bills can also be used to judge the economic scenario. Rising yields can be an alarming signal for the bond market. US treasuries are accepted as a benchmark rate for other bond yields.

Monetary policy decisions can greatly impact the bond prices. As interest rates rise, investors might be interested in investing in stocks because bonds would be priced lower. Conversely, as the economy suffers a slowdown, the demand for money falls. This means that demand for loans also declines, leading to lower interest rates. This makes investors skeptical about stocks, so they prefer investing in bonds.

Thus, positive sentiment in the economy can be detrimental to treasury yields, while a slowdown in the economy can end up being beneficial for the yield on these bonds.

However, some bonds may gain from positive economic changes. These include high-yield bonds, emerging market bonds, and lower-rated corporate bonds. These bonds may not change along with changes in the Treasury yields and thus, do not use them as a benchmark.

With further rise in inflation expected, more economic growth can be on the cards for Australia. However, the RBA has already bought AUD4 billion worth of government bonds followed by significant purchases last week. This is likely to continue as central banks across the globe would attempt to curb the yield hike.

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