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Translating Wall Street: T-Bonds and tea leaves

Thinking about supply and demand in the treasury market can help one understand interest rates.
By Ian Ogilvie Published: July 7, 2013

While current yields are lower, holders of bonds experience a capital gain. They can sell their bonds for much more than they paid for them. Bondholders are happy when interest rates are falling.

10-year Treasuries

Let's apply this logic to 10-year Treasuries, which are the best proxy for interest rates in the economy. What could make the current yield on a 10-year Treasury move higher (as yields have, from about 1.5 percent a year ago to about 2.5 percent now)?

As we've seen, in a bond market, rising current yields mean that their prices have been going lower, because there has been more selling than buying (supply is greater than demand). But why would people be doing more selling of Treasuries than buying?

According to Robert Dauffenbach, associate dean and director at the Center for Economic Management and Research at OU Price Business College, there are numerous reasons why Treasuries can look less attractive to investors, prompting selling (supply) to outstrip buying (demand) and causing prices to go lower and yields higher. He points out that the Fed has been doing a lot of bond buying with its quantitative easing policy, which has helped keep interest rates low by supplementing demand for bonds, which in turn has supported bond prices.

But, queries Dauffenbach, “what happens when the Fed ‘tapers' its purchases?”

Bond demand reduced

Tapering purchases would mean reduced demand for bonds, which should make prices of bonds go down and yields rise, i.e., higher interest rates in the economy. In a rising interest rate scenario, bondholders experience lower prices for their holdings and their portfolios are worth less in the market. The Fed has been signaling reductions in future purchases causing distinct nervousness in the market for bonds.

Treasuries also look less attractive if investors become concerned about inflation, as they tend to shy away from fixed income in a rising price environment and instead favor investments, such as farmland, that are thought to better keep up with inflation. Or if investors think the economy is improving, and they sell Treasuries to reinvest in more risky, better-paying assets. Greater supply than demand could just mean that a large holder of Treasuries (like China) is selling.

How tea leaves work

This is where the tea leaves come in. While expectations of higher interest rates and higher prices may come to pass, they may just as well not. For example, the economy here or elsewhere could take a turn for the worse, causing people to put their money back into Treasuries in a “flight to safety.” Plug that into the supply/demand model: with more buyers (demand) than sellers (supply), Treasury prices will rise forcing their yields, and interest rates in the economy, back down.