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Why the Bond Market Sets the Price
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On August 19, the U.S. Treasury announced that it would at least double its buybacks of longer-dated bonds. Treasury said that the move was designed to improve liquidity in those older securities.
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However, some in the market interpreted it as an attempt to lower longer-term yields. And you can understand why.
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The U.S. government has an enormous amount of debt that continually needs to be refinanced. As older, lower-yielding bonds mature, the government has to issue replacement debt at substantially higher rates. That means the government’s interest bill increases.
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Buying bonds increases demand, which typically pushes their prices higher. And because bond prices and yields move in opposite directions, that puts downward pressure on yields.
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Yet despite initially falling after the Treasury’s buyback announcement, 10-year yields have reclaimed that lost ground and are pushing higher. And that highlights an important point.
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The government can influence the Treasury market around the edges. But it can’t directly control where long-term yields trade.
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Ultimately, yields reflect investors’ expectations around inflation, economic growth, future Fed policy, and the size and trajectory of government debt.
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And when those yields change, the effects permeate right across the economy…
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What Higher Yields Mean for Stocks
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When 10-year Treasury yields rise, borrowing costs throughout the economy typically increase too.
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That’s not just mortgage rates but also things like corporate bonds. They’re usually priced at a premium to Treasurys. That means that the cost of borrowing typically rises for companies too.
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Higher yields can also have an impact on how investors value stocks – especially those priced for strong growth. The higher the rate used to discount those future profits, the lower their present value becomes.
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That’s particularly relevant right now with the enormous valuations placed on AI-themed stocks.
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If borrowing costs increase while a higher discount rate reduces the present value of expected future profits, those stocks could get squeezed from both directions.
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But there’s another major consideration too.
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When Treasury yields were sitting around just 1% or 2%, investors looking for decent returns had relatively few alternatives to stocks. But when U.S. government bonds are yielding close to 5%, the equation starts to change. Stocks need to offer a sufficiently attractive potential return for the additional risk investors are taking on.
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So far, stocks have handled the rise in longer-term yields reasonably well. But if those yields keep rising, the pressure on stocks could continue to build.
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That’s why I’m watching the 10-year just as closely as what the Fed does later this month.
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Because ultimately, a potential 0.25% rate hike is only part of the story. What happens further out on the yield curve could prove much more important for stocks.
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Regards,
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Larry Benedict
Editor, Trading With Larry Benedict
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