As the Federal Reserve aggressively raises interest rates — raising them by three-quarters of a percentage point on Wednesday — the yield on the 2-year Treasury exceeded 4% for the first time since 2007. Meanwhile, the yield on the 10-year note reached 3.53%also hitting a high he hasn’t seen in over a decade.
One of the effects of higher yields on government debt is that companies also pay higher rates on their debt. This generally leads to a slowdown in hiring – which the Fed seems to be aiming for in its efforts to calm inflation.
Kevin Maloney, a finance professor at Bryant University, explained that the 2-year rating “reflects current Fed policy and expectations for the direction of Fed policy.”
“The interest rate the Fed is raising is a very short-term interest rate, the only thing they can control,” Maloney said. “No one will lend money for two years unless they are sufficiently compensated to do so.”
To some extent, the 10-year note also reflects Fed policy expectations, but the link is much less certain. No one can predict with certainty what will happen to inflation and other economic conditions over the next decade.
The yield curve shows the “relationship between short-term and long-term yields,” as Marketplace reported. Since investing in a debt security for a longer period involves more risk, the yield on longer-term bonds will generally be higher than on short-term bonds.
But when the curve is “inverted”, what we are seeing right now is the reverse.
The high short-term rates reflect “that the market is assuming that the Fed will continue to raise interest rates for some time, [and] inflation is going to come down because of that,” Maloney said.
“There is a reasonably high probability that we will have a recession. And then the Fed will have to reverse course and bring it right back down,” he added.
Maloney noted that an inverted yield curve does not directly predict a recession.
“What it does is it predicts that rates are going to go down in the future. That usually happens during recessions. That’s the connection.
Currently, bond valuations are falling, with the performance of the S&P US Aggregate Bond Index down 12.9% year-on-year. Bonds are supposed to provide protection against a stock market decline, but we’re in an environment of rising rates, Maloney said.
This reduces the value of bonds that were issued earlier and have lower yields.
Why? You can sell your bond on the secondary market before it matures. In an era of rising yields, an older bond with a lower yield will be worth less to a potential buyer. Conversely, if interest rates fall, your old bond, with its higher interest rate, will be more valuable.
But either way, if you hold a treasury bill (or note or note) until maturity, you’ll get back the full value with the yield.
With yields rising across the board, Maloney said we’re almost at the point where it makes sense to invest more in bonds.
“I don’t know if we’re quite there. I think we have to skip the next two Fed meetings,” Maloney said. “They are definitely more attractive than they were two years ago, that’s for sure.”
These meetings, during which the central bank normally updates its interest rate policy, are scheduled for early November and mid-December.
But while investors can now earn 4% on the 2-year note, inflation is at multi-decade highs, which means the yield you receive on the note is buying you less, Maloney pointed out.
“The downsides are if inflation doesn’t come down, then you give up purchasing power,” he said.
Let’s say 2-year Treasury bills are part of your retirement portfolio. If you’re only making 4% a year on them, but inflation averages 5% over the next two years, the returns aren’t great for you, Maloney observed. If inflation averages 4%, you would break even on the cost of living.
That might not be so bad, Maloney said, because public debt provides security in a volatile environment. “Because Treasury bills have no credit risk, there is no real risk of losing the principal of the Treasury security,” Maloney said.
This is unlike stocks, which have been a good place to lose money recently. The S&P 500 is down nearly 21% Year after year.
Savings accounts, usually covered by FDIC deposit insurance, are also considered safe, but yields are lower than those offered by bonds.
Keeping your money in bank accounts is a good idea if it’s part of an emergency fund or if you have short-term goals and expenses. But according to Ken Tumin, senior industry analyst at LendingTree and founder of DepositAccounts.com, consumers should consider investing in mutual funds and exchange-traded funds to achieve their long-term financial goals.
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