Most investors care about future interest rates, but none more than bondholders. If you are considering a bond or bond fund investment, you must ask yourself whether you think treasury yield and interest rates will rise in the future. If the answer is yes, you probably want to avoid long-term maturity bonds or at least shorten the average duration of your bond holdings, or plan to weather the ensuing price decline by holding your bonds and collecting the par value when they mature.


Understanding Treasury Yield

The Treasury Yield Curve

In the United States, the Treasury yield curve (or term structure) is the first mover of all domestic interest rates and an influential factor in setting global rates. Interest rates on all other domestic bond categories rise and fall with Treasuries, which are the debt securities issued by the U.S. government. To attract investors, any bond or debt security that contains greater risk than that of a similar Treasury bond must offer a higher yield. For example, the 30-year mortgage rate historically runs 1% to 2% above the yield on 30-year Treasury bonds. 

Below is a graph of the actual Treasury yield curve as of January 21, 2021. It is considered normal in shape because it slopes upward with a concave slope, as the borrowing period, or bond maturity, extends into the future:

Yield Curve
Source: U.S. Treasury Dept,.

Consider three elements of this curve. First, it shows nominal interest rates. Inflation will erode the value of future coupon dollars and principal repayments; the real interest rate is the return after deducting inflation. The curve, therefore, combines anticipated inflation and real interest rates.

Second, the Federal Reserve directly manipulates only the short-term interest rate at the very start of the curve. The Fed has three policy tools, but its biggest hammer is the federal funds rate, which is only a one-day, overnight rate. Third, the rest of the curve is determined by supply and demand in an auction process.

Sophisticated institutional buyers have their yield requirements, which, along with their appetite for government bonds, determine how they bid. Because these buyers have informed opinions on inflation and interest rates, many consider the yield curve to be a crystal ball that already offers the best available prediction of future interest rates. If you believe that, you also assume that only unanticipated events (for example, an unanticipated increase in inflation) will shift the yield curve up or down.

Long Rates Tend to Follow Short Rates

Technically, the Treasury yield curve can change in various ways: It can move up or down (a parallel shift), become flatter or steeper (a shift in slope), or become more or less humped in the middle (a change in curvature).

The following chart compares the 10-year Treasury note yield (red line) to the two-year Treasury note yield (purple line) from 1977 to 2016. The spread between the two rates, the 10-year minus the two-year, (blue line) is a simple measure of steepness:

We can make two observations here. First, the two rates move up and down somewhat together (the correlation for the period above is about 88%). Therefore, parallel shifts are common. Second, although long rates directionally follow short rates, they tend to lag in magnitude.

More specifically, when short rates rise, the spread between 10-year and two-year yields tends to narrow (curve of the spread flattens) and when short rates fall, the spread widens (curve becomes steeper). In particular, the increase in rates from 1977 to 1981 was accompanied by a flattening and inversion of the curve (negative spread); the drop in rates from 1990 to 1993 created a steeper curve in the spread, and; the marked drop in rates from 2000 to the end of 2003 produced an equally steep curve by historical standards.

Supply-Demand Phenomenon

So what moves the yield curve up or down? Well, let's admit we can't do justice to the complex dynamics of capital flows that interact to produce market interest rates. But we can keep in mind that the Treasury yield curve reflects the cost of U.S. government debt and is therefore ultimately a supply-demand phenomenon.

Supply-Related Factors

Monetary Policy
If the Fed wants to increase the fed funds rate, it supplies more short-term securities in open market operations. The increase in the supply of short-term securities restricts the money in circulation since borrowers give money to the Fed. In turn, this decrease in the money supply increases the short-term interest rate because there is less money in circulation (credit) available for borrowers. By increasing the supply of short-term securities, the Fed is yanking up the very left end of the curve, and the nearby short-term yields will snap quickly in lockstep.

Can we predict future short-term rates? Well, the expectations theory says that long-term rates embed a prediction of future short-term rates. But if we consider the actual yield curves observed in the markets over time, unfortunately, the pure form of this theory has not performed well: Interest rates often remain flat during a normal (upward-sloping) yield curve. Probably the best explanation for this is that, because a longer bond requires you to endure greater interest-rate uncertainty, there is extra yield contained in the two-year bond. If we look at the yield curve from this point of view, the two-year yield contains two elements: a prediction of the future short-term rate plus extra yield (i.e., a risk premium) for the uncertainty. So we could say that, while a steeply sloping yield curve portends an increase in the short-term rate, a gently upward-sloping curve, on the other hand, portends no change in the short-term rate—the upward slope is due only to the extra yield awarded for the uncertainty associated with longer-term bonds.

Because Fed-watching is a professional sport, it is not enough to wait for an actual change in the fed funds rate, as only surprises count. It is important for you, as a bond investor, to try to stay one step ahead of the rate, anticipating rather than observing its changes. Market participants around the globe carefully scrutinize the wording of each Fed announcement (and the Fed governors' speeches) in a vigorous attempt to discern future intentions.

Fiscal Policy
When the U.S. government runs a deficit, it borrows money by issuing longer-term Treasury bonds to institutional lenders. The more the government borrows, the more supply of debt it issues. At some point, as the borrowing increases, the U.S. government must increase the interest rate to induce further lending.

However, foreign lenders will always be happy to hold bonds in the U.S. government: Treasuries are highly liquid and the U.S. has never defaulted on a major scale (it actually came close to doing so in late 1995, but Robert Rubin, the Treasury secretary at the time, staved off the threat and has called a Treasury default "unthinkable—something akin to nuclear war"). Still, foreign lenders can easily look to alternatives like Eurobonds and, therefore, they are able to demand a higher interest rate if the U.S. tries to supply too much of its debt.

Demand-Related Factors

If we assume that borrowers of U.S. debt expect a given real return, then an increase in expected inflation will increase the nominal interest rate (the nominal yield = real yield + inflation). Inflation also explains why short-term rates move more rapidly than long-term rates: When the Fed raises short-term rates, long-term rates increase to reflect the expectation of higher future short-term rates; however, this increase is mitigated by lower inflation expectations as higher short-term rates also suggest lower inflation (as the Fed sells/supplies more short-term Treasuries, it collects money and tightens the money supply):

Interest Rates
Image by Julie Bang © Investopedia 2021

An increase in fed funds (short-term) tends to flatten the curve because the yield curve reflects nominal interest rates: higher nominal = higher real interest rate + lower inflation.

Fundamental Economics

The factors that create demand for Treasuries include economic growth, competitive currencies, and hedging opportunities. Just remember: Anything that increases the demand for long-term Treasury bonds puts downward pressure on interest rates (higher demand = higher price = lower yield or interest rates) and less demand for bonds tends to put upward pressure on interest rates.

A stronger U.S. economy tends to make corporate (private) debt more attractive than government debt, decreasing demand for U.S. debt and raising rates. A weaker economy, on the other hand, promotes a "flight to quality," increasing the demand for Treasuries, which creates lower yields. It is sometimes assumed that a strong economy will automatically prompt the Fed to raise short-term rates, but not necessarily. Only when growth translates or overheats into higher prices is the Fed likely to raise rates.

In the global economy, Treasury bonds compete with other nations' debt. On the global stage, Treasuries represent an investment in both the U.S. real interest rates and the dollar. The euro is a particularly important alternative: For most of 2003, the European Central Bank pegged its short-term rate at 2%, a more attractive rate than the fed funds rate of around 1%. 

Finally, Treasuries play a huge role in the hedging activities of market participants. In environments of falling interest rates, many holders of mortgage-backed securities, for instance, have been hedging their prepayment risk by purchasing long-term Treasuries. These hedging purchases can play a big role in demand, helping to keep rates low, but the concern is that they may contribute to instability.

The Bottom Line

We have covered some of the key traditional factors associated with interest rate movements. On the supply side, monetary policy determines how much government debt and money are injected into the economy. On the demand side, inflation expectations are the key factor.

However, we have also discussed other important influences on interest rates, including fiscal policy (that is, how much does the government need to borrow?) and other demand-related factors such as economic growth and competitive currencies.

Here is a summary chart of the different factors influencing interest rates:

Major Factor Key Metric(s) For example: Translates Into:
Monetary Policy Federal Funds Rate Higher short-term Federal funds rate (achieved by increasing the supply of short-term securities or a "tightening" of the money supply)... increase in short-term rates and, to a lesser extent, an increase in long-term rates.
Fiscal Policy Budget Deficit Larger deficit requires greater supply of bonds (government borrowing)... ...upward pressure on all rates, especially long bonds.
Major Factor Key Metric(s) For example: Translates Into:
Inflation Consumer Price Index (CPI) or Producer Price Index (PPI) Higher inflation directly translates into... ...higher nominal interest rates.
Fundamental Demand Foreign and domestic uses of US government debt More attractive European bonds... ...upward pressure on government bonds (i.e., to remain competitive).