The income of the US Government is not enough to cover its spending. The US Treasury issues government “bonds” on a regular basis, to cover government spending. When you buy such a bond, you are in fact, becoming a creditor to the US government.
Treasuries are classified as treasury bills, notes and bonds. But what’s the difference between them?
The difference between bills, notes and bonds are the length until their maturity:
- Treasury bills (T-bills) are issued for terms less than a year.
- Treasury notes (T-notes) are issued in terms of 2, 3, 5, and 10 years.
- Treasury bonds (T-bonds) are issued in terms of 30 years.
Treasuries are considered to be the safest form of investment, since they are vouched for by the US government. As such, they offer the lowest rate of return as well.
US Treasuries are considered a safe haven. Whenever there is a market shock, investors will flock to this instrument even though it offers low yields. This is also called “flight to quality”. The more Treasuries are sought after, the higher their price becomes, and this pushes treasury bond yields down.
Conversely, when the economy is in good shape, investors will exit treasuries holdings, looking for higher returns elsewhere on the market. Selling treasuries drives their price down, which increases their yield.
Because of this, trading Treasuries means a direct exposure to US and global economic events and interest rates.
Inverse price/yield relationship
It is important to understand, that:
- when bond prices increase, yields drop
- when bond prices decrease, yields grow
If you plot the yield of Treasuries with differing maturities on a graph where the x axis is time, and the y axis is yield, you get the yield curve. As such, the yield curve is a comparison of yields on all treasuries, from the short-term Treasury bill to the longest-term Treasury bond.
The yield curve is in constant change, as the yields of treasury bills, notes and bonds change. In a healthy economy, the longer time you have till maturity, the higher the yield should be. If you ever see an inverse yield curve, trouble is on the way, as investors are pricing in a recession.
The 2-10 year treasury spread is of great interest to investors. It shows the difference between the yields of the 10 year note, and the 2 year note, as being emblematic of the difference between short term yields, and long term yields. Here is the 2-10 treasuries spread.
The 10 year note rate is the most important, because it is the benchmark rate that guides other interest rates.
What to watch
Since yields are closely related to the economy, you need to keep track of the more important economic indicators. Changes in these will have direct influence on bond prices and yields:
Both a declining economy, and an overheated economy (because of more inflation) will drive yields down.
The current government always has a GDP target. If the actual GDP strays too far off what is planned, the government will intervene to bring it back, which will affect bond prices as well.
A strong work force numbers means an expanding economy, therefore lower treasuries prices, equaling higher yields. Most importantly, watch the monthly non-farm payroll report, due out at the beginning of the month.
The Federal Reserve’s Open Market Committee (FOMC) sets the federal funds rate. It meets 8 times a year to review economic conditions and determine the proper course of monetary policy needed to pursue its stated goals of “price stability and sustainable economic growth.”
The FEDs modification of interest rates will have an effect on the shorter end of the yield curve, so treasury bills and notes.
The government uses fiscal policy (spending and taxation) to influence aggregate demand.
Different administrations have different philosophies when it comes to the use of fiscal policy to control economic activity. For example, one administration may be hesitant to use fiscal policy, and another might favor tax cuts over spending. Or vice versa.
Knowing the current administration’s fiscal policy philosophy can help investors and traders anticipate the likely impact of changes in economic data.
In an overdriven economy with high inflation, investors demand higher yields, driving bond prices down.
A budget deficit occurs when the government spends more than its income.
The worst case is when you have high inflation, coupled with a budget deficit. This is because overspending (deficit) can lead to higher inflation and cause damage to the economy via:
- The crowding out effect
- Monetary tightening
Dependence on foreign investors
Foreign governments holds trillions of $ worth of US treasuries. The most notable of these is China. If it were to start selling it’s holdings, it would have a direct effect on prices and yields.
Here are the foreign holders of US treasuries, and if you like, you can see other reports on this as well. (When looking at the data, keep in mind that some countries may hold treasuries through another country. For example, China held more through Belgium.)
Bond pricing rules of thumb
Bond prices exhibit strong correlation with specific market events, so trading treasuries futures offers traders the ability to take advantage of world events be it short, or long.
- Stock market
- Bull stock market: treasuries prices fall -> yields increase
- Bear stock market: treasuries prices increase -> yields decrease
- Interest rates
- Increasing interest rates: existing treasuries prices fall -> yields increase
- Decreasing interest rates: existing treasuries prices increase -> yields decrease
- Growing economy: treasuries prices decrease -> yields increase
- Shrinking economy: treasuries prices increase -> yields decrease
- Growing inflation: treasuries prices decrease -> yields increase
- Shrinking inflation: treasuries prices increase -> yields decrease
Of course, if you hold the bond till maturity, bond price increases/decreases don’t effect you. It’s only if you actively trade bonds.
Data to track
- CPI index – available around the middle of every month, at 8:30 ET, check the schedule here
- GDP report – released at the end of each month, here is the schedule
- Personal income report – released at the end of each month, here is the schedule
- Non-farm payroll report – available on first Friday of every month, at 8:30 ET
Instruments to trade
The most traded treasuries futures are the 30-year bond, 10-year note, and the 5-year note. They are traded at the CME.
The 30 year bond is the most volatile, since forecasting interest rates 30 years out is impossible. The 2 year note is much less volatile.