Why the 10-year bond rate matters

Unless you have been hiding underneath a rock, you know that interest rates have been marching higher since the Federal Reserve began its inflation-fighting campaign.

Although the central bank only controls shortterm rates, intermediate and longer-term rates have followed suit.

Over the past two years, the yield of the benchmark 10-year treasury has gone from about 1.5% in October 2021 to a recent high of just over 5%, a level not seen since July 2007.

The increase means that the U.S. government must pay higher interest for borrowed funds. But there's a reason that the 10-year is called the “benchmark.” It is the bond on which a lot of other lending rates are derived, like mortgage rates, student loan rates, and car loans, all of which have been rising in concert with the yield of the 10-year.

As a reminder, a bond purchase is essentially a loan to an entity, which can be a government, a state, a municipality, or a company. The loan is established for a predetermined period, at a fixed rate of interest. Borrowers are on the hook for interest payments, either at periodic intervals (usually every six months), or at the end of the agreement, when they repay the obligation in full.

Because bonds deliver a consistent stream of income, investors have seen them as an integral part of a diversified portfolio. In fact, fixed income investments have historically provided ballast against stocks, which tend to be more volatile.

But investors have learned that prices for bonds can fluctuate. As an example, if you purchased a 10-year bond that paid 1.5% a couple of years ago, it will be worth less now, when new bonds issued by Uncle Sam are paying almost 5%.

Conversely, if you owned a bond that is paying 10% and your friend can purchase a new bond at 5%, your bond is more valuable today than the prevailing bonds she can purchase. In other words, bond prices generally move in the opposite direction of prevailing rates, regardless of the bond type.

With all of this said, you may be wondering why rates have jumped so dramatically, especially over the past 90 days or so. The answer, according to Madison Faller, Global Investment Strategist at JP Morgan Chase, is due to “inflation, growth, and uncertainty.”

Inflation was the main culprit for bond prices tanking (and yields rising) last year. Inflation means that a bond's fixed stream of interest payments is worth less over time due to rising prices.

But Faller thinks that inflation is not the main catalyst in the current bond market action. She argues that better than expected growth — powered by strong consumer spending, a resilient labor market, and an uptick in productivity, could mean “that the Fed will keep interest rates `higher for longer,' even if it's pretty much done hiking.”

Adding to the growth story is uncertainty, which can come in the form of worries about terrorism/ war and renewed concerns about the federal budget deficit, which swelled to $1.7 trillion in 2023. Uncertainty causes investors to demand higher rates (and pushes

prices down) to compensate them for the risk of locking up their money for 10 years.

While “it hurts to see the value of your bonds fall,” says Brenna McLaughlin, of Wealthstream Advisors, “those bonds will continue to pay the same coupon and will be redeemed at the agreed upon maturity value, even though their market value may suffer in the short term.”

And if you are sitting on cash, McLaughlin points out that “this could be a great opportunity to shift into bonds and lock in attractive yields for the longer-term.”