The U.S. 10-year Treasury note is the benchmark debt obligation issued by the U.S. government. Backed by the full faith and credit of the U.S. government, it is one of the most popular debt instruments in the world. It’s yield, the rate of return one gets for investing in the note, is used to set interest rates for many forms of consumer and business long-term debt, such as mortgages, car loans and the financing of machinery and equipment.
The yield on the 10-year Treasury note has been rising, and on Wednesday, closed at 3 percent — a barrier that many in the financial markets view as a harbinger of economic and stock market concern. It was the highest yield since January 2014 and marked a significant increase from the 2.41 percent yield at the start of the year and the all-time low of just 1.33 percent, set in July 2016.
So, why are the financial markets concerned over the rate of the 10-year Treasury note reaching 3 percent? Most on Wall Street will readily admit the 3 percent barrier isn’t a hard line in the sand — where a 2.95 percent yield is OK, but 3 percent or higher represents some impending doom. However, it does highlight the challenges posed when interest rates start to rise above a certain level.
For the past year, a strengthening U.S. economy, labor market and global economy have raised concerns of rising inflation. Robust demand for goods and services fuels our economy, but also drives prices higher. To prevent prices from skyrocketing that could prematurely halt consumer and business spending, the Federal Reserve gently taps the breaks on the economy by gradually raising the cost of debt through coordinated interest rate hikes.
Since December 2015, the Fed has implemented six 0.25 percent rate hikes to the benchmark fed funds rate, upon which short-term debt is often based. The most recent rate hike was in March, with two more expected this year and three in 2019. These rate hikes, along with other Fed monetary policy measures, have helped drive up both short-term and long-term interest rates.
However, continuing strength in the U.S. economy and labor market and surging corporate profits caused concern the Fed will become even more aggressive in raising interest rates to keep inflation in check.
As a key driver of long-term interest rates, a 10-year Treasury note yield of 3 percent or more pushes long-term borrowing costs to a level that can have a material impact. For consumers, there is less demand for car loans, home mortgages and personal loans for big-ticket purchases. For businesses, the increased borrowing costs on equipment, technology and infrastructure decrease their profit margins, which is reflected in their corporate earnings and stock price.
As an example, we look to Caterpillar, which announced its first quarter earnings on Tuesday. Caterpillar reported record revenues, achieving the highest first quarter profit in its 93-year history. In addition, it projected continued growth on solid customer demand for its goods and services. However, their comment that first quarter profits (revenues less expenses) would be “the high water-mark for the year” sent the stock plummeting. On Tuesday, the stock fell $9.55, or 6.2 percent, to close at $144.44. As Caterpillar is often viewed a proxy for the health of the U.S. economy and stock market, the Dow Jones Industrial Average fell 425 points, reflecting concerns of higher borrowing costs for the rest of corporate America.
Now, reaching the 3 percent barrier on the 10-year Treasury note is not the end of the world. Historically, the American economy and stock markets have thrived in a similar environment. And remember, the higher interest rates result from a strong and vibrant economy. Due to global economic growth, nations around the world are also experiencing rising interest rates.
Yes, it does raise alarm bells for the future profitability of U.S. companies. Also, higher yields on bonds pull money away from the stock market as investors flee the uncertainty of stocks for the safety and security of bonds that now offer a higher return. All eyes are on the Fed. Rising interest rates carry risks, and over the upcoming year, the Fed must enact its rate hike agenda with minimal disruption to the markets.