What is the 10-Year US Treasury Note (US 10Y) and How Does it Affect Financial Markets?
Famed economist and Nobel Prize recipient Friedrich Hayek’s groundbreaking research/analysis on the correlation between interest rates, speculative asset price inflation and financial calamity revolutionized economics. And since we have been recently getting a lot of inquiries related to how the shift in interest rates and the 10-year treasury note yield affects financial markets, we thought it was an opportune time to remember him and this blog post digs deeper into that.
What does the 10-Year Note yield tell us?
The yield on the 10-year treasury note provides insights into growth expectations, inflation expectations, and fiscal stability/instability.
All else being equal, higher yields generally suggest expectations for faster economic growth, higher inflation and fiscal weakness/instability.
On the flip side, lower yields generally suggest expectations for slower economic growth, lower inflation, and fiscal strength/stability.
What is the meaning of the 10-Year Note?
The 10-year note is a fixed interest rate US government debt obligation for borrowing money with a 10 year maturity.
The fixed interest rate is paid semiannually with the principal paid back at par value when the note matures.
How does the 10-Year Note influence financial markets?
The 10-year note is a proxy for the risk-free rate of return which provides the benchmark by which all asset classes and their respective returns are measured.
Asset allocation models and macroeconomic valuation tools like the “equity risk premium” and “Merton Share” measure and calculate the expectation for returns between risky assets and the risk-free rate of return benchmarked by the 10-year note.
As a first principle of market function when the cost of capital (10-year note yield) is lower than the return on capital for risky assets (e.g. earnings yield of the S&P 500) asset prices generally rise over the long term and conversely when the cost of capital is higher than the return on capital asset prices generally move lower over the long term.
In theory, it is not the absolute levels of yields that matter most, but the gap or excess between the cost of capital and return on capital. The greater the spread or difference between the cost of capital and return on capital the greater the magnitude of the increase or decrease in asset prices over the long term.
How does the 10-Year Note affect investors?
The 10-year note yield establishes the opportunity cost for investors that desire to invest in risky assets.
Higher 10-year note yields generally reflect a higher opportunity cost for investors while lower 10-year note yields generally reflect a lower opportunity cost. For example, in 2020 when the Federal Reserve and central banks globally flooded the markets with fiscal and monetary stimulus in response to the pandemic, the 10-year note yield was at rock bottom levels which spurred a speculative mania in financial markets as there was almost zero opportunity cost for holding risky assets.
In principle, artificially low interest rates inflate asset prices, whereas higher interest rates deflate asset prices.
How liquid are 10-Year Treasuries?
The 10-year note is well known as one of the deepest and most liquid markets in the world.
Holders include foreign governments, sovereign wealth funds, banks, pension funds, hedge funds, family offices and other financial institutions around the globe.
What are the effects if the 10-Year Note yield moves lower?
In theory, all else being equal, a lower 10-year note yield should reduce borrowing costs and inflate asset prices over the long term as the cost of capital declines, but since markets are irrational in the short term we must focus on aggregate market positioning and market price action to interpret the market’s message in the face of lower yields.
What are the effects if the 10-Year Note yield moves higher?
In theory, all else being equal, a higher 10 year note yield should increase borrowing costs and deflate asset prices over the long term as the cost of capital increases, but since markets are irrational in the short term we must focus on aggregate market positioning and market price action to interpret the market’s message in the face of higher yields.
What are the effects of the 10-Year Note yield on other asset classes?
The 10-year note yield directly influences the interest rates set for mortgages, real estate loans, the risk-free rate of return, corporate bonds, municipal bonds, government bonds and a plethora of other lending activities in the financial markets.
How does the 10-Year Note affect mortgage rates?
The 10-year note is the benchmark for setting 30-year fixed mortgages in America. Higher 10-year note yields generally reflect higher mortgage rates and conversely lower 10-year note yields generally reflect lower mortgage rates.
All else being equal, lower mortgage rates generally equate to higher real estate prices, and conversely higher mortgage rates generally equate to lower real estate prices.
Who benefits from lower yields on the 10-Year Note?
Borrowers, debtors and equity investors typically benefit most from lower yields as this decreases their cost of capital and opportunity cost for all financial transactions. A perfect example is a real estate investor purchasing a portfolio of single-family rental properties with borrowed money will have a lower debt service cost or cost of money when interest rates on mortgages fall.
Who benefits from higher yields on the 10-Year Note?
Lenders, creditors and bond investors typically benefit most from higher yields on the 10-year note as the interest rate payments they receive from their lending activity typically rise. For example, a bond investor will capture a higher interest rate from their lending activity when yields rise.
If you are a family office or institutional investor and have questions around the 10-year note and its impact on financial markets globally, let’s connect and explore what’s possible.