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How Treasury Yields Affect Your Portfolio Dear Tejas, Federal Reserve Chairman Jerome Powell surprised both me and the stock market with his hawkish comments at the Kansas City Fed’s annual conference in Jackson Hole, Wyoming, last Friday morning. He said: “We must keep at it until the job is done.” As a result, stocks got crushed on Friday and wiped out their entire month’s gains, ultimately ending August down more than 4% across the board. Powell also implied that “with inflation running far above 2% and the labor market extremely tight,” additional rate hikes after September 21 may be necessary. Consider this: After the 75-basis-point rate hike on September 21, the federal funds rate will be at 3%, and the Fed will be “neutral” and in synch with Treasury yields. That’s part of what makes Powell’s comments shocking. The Fed never fights market rates. Personally, I still think the Fed will raise rates by 75 basis points on September 21 and then take a break. Any further fine tuning on interest rates will likely happen in December when most folks are distracted by the holidays. I don’t anticipate a rate hike in November, as the Federal Open Market Committee (FOMC) meeting is only six days before the mid-term elections, and the Fed has never raised rates right before an election. But the fact is the stock market does not like uncertainty, and unfortunately, Powell did not paint a clear picture of where the Fed and inflation are heading. As a result, the 10-year Treasury yield rose back above 3% and now sits at about 3.26%. And if there is one thing that Wall Street is afraid of it’s rising Treasury bond yields. The higher Treasury yields soar, the more the Fed must raise key interest rates to get to “neutral.” So, in today’s Market 360, we’re going to take a deeper dive into Treasury yields and what they mean for the market and your portfolio. What Is a Treasury Yield? Treasury yields are basically the interest you earn when you own U.S. Treasury bills, notes, bonds or inflation-protected securities. The U.S. Department of Treasury sells these securities as a way to pay for the U.S. debt. The first thing to know about bond yields is that they move inversely to bond prices, just like a dividend stock. If the price of the bond goes down, you are earning a higher rate of return because you paid less. The opposite is true when board prices go up. So, whenever you see the yield rise, the price of the bond is falling. The second thing to know is that Treasury prices fluctuate with supply and demand. Treasury bonds are sold at auction initially, but they can also be bought and sold in the secondary market after they are issued. If there is a lot of demand, the bond will sell for a price above face value, which then lowers the yield. On the other side, if there is less demand, then the price of the bond will be lower and the yield will rise. At maturity, the government will pay back the face value of the security with interest. Because Treasury bills are backed by the U.S. government, people view them as very secure. That’s why demand for Treasury bonds goes up (and consequently forces yields down) in times of economic uncertainty. Securities with a long-time horizon often have the highest interest rates. Investors demand a higher return if they have to wait longer until maturity. This gets us to what’s called the “yield curve,” which you have probably heard a lot about this year because it is one of the most-watched indicators when it comes to signaling recessions. The yield curve refers to the relationship between short-term yields and long-term interest yields. As we said, long-term bonds pay a higher yield than short-term bonds in a normal market. You can see a normal yield curve in the chart below, created by my InvestorPlace colleagues John Jagerson and Wade Hansen for their Strategic Trader readers. The black line is the long-term yield (10 year), and the red line shows the short-term yield (two year). The yield curve “flattens” when long-term and short-term rates are about the same, and it “inverts” when short-term yields rise above long-term yields. This inverted yield curve when two-year bonds yield more than 10-year bonds has correctly predicted every recession over the past 50 years. That happened again back in June. So, what are the yields telling us now? And what does it mean for your portfolio? Treasury Yields and Your Portfolio | |