The yield on Treasury bonds has been rising quickly. Since the beginning of 2009, the yield on the 10-year note has risen from 2.14 percent to 3.64 percent, an increase of nearly 80 percent in less than six months.
Treasuries have been rising as the magnitude of the federal deficit becomes clearer to investors. A $1.5 trillion budget shortfall will require the government to issue a lot of bonds. Additional financing will be required to meet the long-term shortfalls in Social Security and Medicare.
Basic economic theory suggests that as the supply of anything increases, its price declines. This has proven to be true in Treasury securities as well. And, as bond prices fall, interest rates go higher.
Investors demand more and more compensation in the form of interest payments to hold something that is going down, which is the value of their bonds denominated in dollars.
The yield on Treasuries is especially important to the economic recovery. Traditionally, this rate has been tied very closely to the interest rate that homebuyers pay on their mortgages.
The historic relationship has shown that mortgages are usually priced about 1.5 to 2 percent more than the 10-year Treasury. The average is 1.7 percent, and that is about where mortgage rates are right now.
If the trend towards higher interest rates continues and mortgages also continue to become more expensive, the recovery in housing prices will take even longer. Higher mortgage rates make it difficult for home builders to resume development. They also make it difficult for potential home buyers to qualify for financing.
If housing doesn’t recover, the green shoots that Fed Chairman Ben Bernanke is optimistically seeing are very likely to turn into dandelions.
We are also seeing the sell-off in bonds hurt the U.S. dollar. Initially benefiting from a flight to quality as the financial crisis accelerated, the dollar has recently been sold off by investors who see its supply increasing rapidly. It is now off almost 15 percent in only three months, a large move for the dollar.
With no signs that the government is about to slow down the printing press, the value of the dollar is likely to continue to fall. As the dollar falls, interest rates will continue to rise. This means investors are continuing to sell Treasuries and putting those dollars to work in other fixed-income areas.
Municipal bonds have been showing strong gains in recent weeks. In the past, these bonds were viewed as tax shelters for high net worth individuals. Now it appears that investors are switching to this beaten-down group to capture potential capital gains.
Given the uncertainty in the economy and the risk that states and cities may face bankruptcies at some point, diversification is important and individuals should not try to pick individual bonds. Mutual funds or exchange-traded funds (ETFs) offer a diversified approach to investing in munis.
Emerging market debt also is delivering profits to investors. Bonds issued by companies in developing economies come with more risk, but part of that risk is offset by the falling dollar. There are several exchange-traded funds that make it possible for individual investors to participate in this investment.
Overall, the increasing yields on Treasury securities can have negative impacts on the economy. They can put an abrupt end to the budding recovery. However, they also offer an opportunity for astute investors to capture gains in other fixed-income investments as we continue to see investors flee from investments backed by the U.S. government.
© 2017 Newsmax. All rights reserved.