Bonds: Treasury Yields and Interest Rates

Investors who own bonds or a bond fund watch to see if Treasury yields and interest rates will rise and to what extent. If rates are increasing, they may avoid bonds with longer-term maturities, shorten the average duration of their bond holdings, or plan to weather the ensuing price decline by holding their bonds to maturity to recoup par value and collect coupon payments.

Key Takeaways

• Any bond riskier than a Treasury bond with the same maturity must offer a higher yield.
• The Treasury yield curve shows the yields for Treasury securities of different maturities.
• The Treasury yield curve reflects the cost of U.S. government debt.
• Supply and demand-related factors shift the yield curve.

Treasury Yields

U.S. Treasury debt is the benchmark used to price other domestic debt and is a factor in setting consumer interest rates. Yields on corporate, mortgage, and municipal bonds rise and fall with those of the Treasuries, debt securities issued by the U.S. government.

To attract investors, any bond riskier than a Treasury bond with the same maturity must offer a higher yield. For example, the 30-year mortgage rate historically runs about one to two percentage points above the yield on 30-year Treasury bonds.

The Treasury yield curve (or term structure) shows the yields for Treasury securities of different maturities. It reflects market expectations of future interest rate fluctuations over varying periods.

Yield Curve Example

Below is an example of the Treasury yield curve. This yield curve is considered normal because it slopes upward with a concave slope as the borrowing period, or bond maturity, extends into the future.

The curve shows nominal interest rates. Inflation will erode the value of future coupon and principal repayments. The real interest rate is the return after deducting inflation. So, the curve reflects the market’s inflation expectations.

The Federal Reserve controls only the short-term interest rate at the extreme left of the curve. It sets a narrow range for the federal funds rate, the overnight rate at which banks lend each other reserves. Supply and demand in the auction process determine the curve.

Like all markets, bond markets match supply with demand; in the case of the market for Treasury debt, much of the demand comes from sophisticated institutional buyers. Because these buyers have informed opinions about the future path of inflation and interest rates, the yield curve offers a glimpse of those expectations in the aggregate.

Long Rates Follow Short Rates

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)
• 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.

The two rates move up and down somewhat together (the correlation for the period above is about 88%). Parallel shifts are common. Although long rates directionally follow short rates, they tend to lag in the magnitude of the move.

When short rates rise, the spread between 10-year and two-year yields tends to narrow (the curve of the spread flattens), and when short rates fall, the spread widens (the curve becomes steeper). 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.

4.51%

The 10-year yield as of Feb. 11, 2025; up from 4.17% on Feb. 9, 2024.

Supply-Demand Phenomenon

What moves the yield curve up or down? Complex dynamics of capital flows interact to produce market interest rates, but the Treasury yield curve reflects the cost of U.S. government debt and is a supply-demand phenomenon.

Supply-Related Factors

Central Bank Purchases: The Federal Reserve has purchased Treasury debt to ease financial conditions during downturns in a policy known as large-scale asset purchases or quantitative easing (QE) and can sell government debt on its balance sheet during recovery in a quantitative tightening. Because large-scale asset purchases (and sales) of securities by a central bank can force other market participants to change their expectations, they can have a counterintuitive effect on bond yields.

Fiscal Policy: When the U.S. government runs a budget deficit, it borrows money by issuing Treasury debt. The more the government spends keeping revenue constant, the higher the supply of Treasury securities. At some point, as the borrowing increases, the U.S. government must increase the interest rate to induce further lending, all other things being equal.

Demand-Related Factors

Federal Funds Rate: If the Fed increases the federal funds rate, it is effectively increasing rates across the spectrum since it is effectively the lowest available lending rate. Because longer-term rates tend to move in the same direction as short-term ones, fed fund rate changes also influence the demand for longer-dated maturities and their market yields.

U.S. Trade Deficit: Large U.S. trade deficits lead to the accumulation of more than $1 trillion annually in the accounts of foreign exporters and foreign central banks. U.S. Treasuries are the largest and most liquid market in which such export proceeds can be invested with minimal credit risk.

Regulatory Policies: The adoption by bank regulators of higher capital adequacy ratios requiring increased holdings of high-quality liquid assets increased the attraction of Treasury notes for banks. Public and private pension plans and insurance company portfolios must also satisfy risk regulators while threading the needle between delivering the required returns and limiting the volatility of those returns. They are another source of demand for Treasuries.

Inflation: If buyers of U.S. debt expect a given real return, then an increase in expected inflation will increase the nominal interest rate (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 restrained by reduced inflation expectations because higher short-term rates also imply lower future inflation as they curb lending and growth:

Interest and Inflation Rate Changes

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

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 leads to lower yields.

It is sometimes assumed that a strong economy will automatically prompt the Fed to raise short-term rates, but not necessarily. The Fed is only likely to raise rates if growth spurs unwelcome inflation.

What Determines Treasury Yields?

Treasury yields are determined by interest rates, inflation, and economic growth, factors which also influence each other as well. When inflation exists, treasury yields become higher as fixed-income products are not as in demand. Strong economic growth also leads to higher treasury yields.

What Happens When Treasury Yields Go Up?

When yields rise, this signals a drop in the demand for Treasuries because investors are bullish about the economy and seek higher returns elsewhere. These investors believe there is a reduced need to invest in safer investments, such as Treasuries.

Why Do Treasury Yields Rise With Inflation?

Treasury yields rise with inflation to make up for the loss in purchasing power. Interest rates and bond yields increase, and prices decrease when inflation exists.

The Bottom Line

Longer-term Treasury bond yields move in the direction of short-term rates, but the spread between them tends to shrink as rates rise because longer-term bonds are more sensitive to expectations of a future slowing in growth and inflation brought about by the higher short-term rates. Bond investors can minimize the effect of rising rates by reducing the duration of their fixed-income investments.