This is a guest post (part 2 in a 3-part series) by Sam, author of Financial Samurai, “How to Engineer Your Layoff,” and founder of the Yakezie Network. Part 1 is A primer on the most important economic metric and Part 3 is A primer on the most important economic metric (part 3).

We started to explore the 10-year Treasury yield in my first post earlier this month and looked at why it is such an important economic metric. In this part of the primer, we’ll explore three more things the 10-year Treasury yield can tell us about the markets. Remember that in my first post, I was using a 10-year yield at 2.7 percent to illustrate my assumptions.

When we left off, I had explained how to think about your investments in the stock market by understanding that the 10-year Treasury yield establishes your opportunity cost. Then I outlined how it is used to understand inflation: “If you understand the 10-year treasury yield, you have an idea, more or less, of where inflation expectations are at any time in history. In 1990, the 10-year Treasury yield was around 9 percent. That means inflation was running likely between 6 to 9 percent a year.”

I went on to explain that “… there is no inherent bad or good Treasury yield number. If Treasury yields are high, then asset inflation is high, which is good for asset holders and bad for price takers. When Treasury yields are low, asset-light investors are hurting less and should use this time to accumulate more assets.”

Let’s press on from there.

What the Treasury yield tells us — part 2

* Risk appetite. If investors are accumulating bonds with yields below 2 percent, that means there is a “risk off” mentality. Investors are willing to accept under 2 percent annual returns because something bad must be going on in the world to run away from equities, which have historically returned 8 percent. Look at how Treasury yields dropped during the dotcom bubble, Gulf War, SARS epidemic, and housing crisis. Investors were basically screaming “save me!” as stocks and real estate declined.

If investors aren’t willing to buy US Treasuries yielding much higher levels such as 8 percent, it must mean that there’s a “risk on” mentality where there are potentially much more lucrative investments from which to choose. There may also be the expectation of much higher inflation and, therefore, higher rates due to perhaps an extremely loose monetary policy and a very tight labor market. Treasury yields can tell the overall market’s risk appetite.

* How the world sees the US. As we discussed earlier, foreigners are huge buyers of US Treasuries. The lower the Treasury yield, the more accepting the financial world is of the United States — otherwise foreigners would be selling Treasuries instead. If the United States suddenly threatened to launch nuclear weapons against Canada and Mexico to expand their footprint, Treasuries would sell off in a hurry and yields would spike.

The problem with being a big holder of US Treasuries is that if a country like China ever wants to sell, they may cause a huge dislocation in the Treasury markets. Hence, foreigners are almost stuck into continuously buying our debt even when yields are so low.

There is a lot of angst against US foreign policy, but the important thing to focus on as an investor is watching what institutions do with their money and not what they say.

* Profit opportunities. There is a big world of macro investors out there who move a lot of money. George Soros may be one of the most famous macro investors who broke the Bank Of England by shorting the pound and making a billion dollars in 1992. I don’t recommend macro investing until you’ve got a good grasp on economics and finance, but you can be your own “mini” macro trader with the 10-year Treasury yield.

I’m a big fan of exchange traded funds (ETFs). The easiest 7-10 Year Treasury bond fund is the un-leveraged ETF IEF by iShares. IEF goes up when yields go down (Treasury prices go up). If you want to profit from rising rates (falling Treasuries), then you can buy the inverse bond ETF TBF called the ProShares Short 7-10 Year Treasury.

For those who are confused with the inverse relationship between bonds and yields, here is a simple example:

Bond Yield = Coupon Payment/Bond Price

  • Bond price = $100
  • Coupon payment = $10
  • Bond yield = 10 percent

If the bond price goes down 50 percent to $50, the coupon stays at $10, then the bond yield rises to 20 percent ($10/$50 = 20 percent).

If the bond price goes up by 50 percent to $150, the coupon stays at $10, then the bond yield falls to 6.7 percent ($10/$150 = 6.7 percent).

Conclusion: US Treasury bonds should be a part of every person’s portfolio. You can buy bonds to profit, hedge, or reduce volatility in your portfolio. Always check whether you need to “re-balance” once a year.

So there you have it. The 10-year Treasury yield, can give you a good idea of your opportunity cost to invest, where inflation is at any given point, and how you should feel about risk. It can also provide insight into how US foreign policy may affect markets and how to identify profit opportunities. Pretty powerful stuff if you ask me!

In the third part of my series on the 10-year US Treasury yield, I will share how I use this simple metric in my own net worth asset allocation.

Readers, what are some important financial metrics you follow? If you have any questions on the 10-year government bond yield, please feel free to ask.

This article is about Advanced, Investing