Stimulus news, the unemployment rate, and vaccine rollouts have all been top of mind for investors keeping an eye on bank stocks this past year. While all of these are certainly important for the sector, a lesser-known metric investors should add to their watch list is the 10-year Treasury note and its accompanying yield. The rise in the yield of the 10-year Treasury note is one of the main reasons bank stocks have rallied as of late, and it could continue to fuel bank stocks in 2021.
What is the 10-year Treasury note?
At its most basic level, the 10-year Treasury note is a bond issued by the U.S. government that matures in 10 years. That's right, investors in the 10-year Treasury note are essentially lending the government money and getting paid back with interest. Because U.S. Treasury bills are backed by the government, and therefore deemed incredibly safe, the interest paid on them is not a lot, with longer-term Treasury notes paying out higher rates than shorter-duration notes.
Image source: Getty Images.
While the interest rate on Treasury notes is highly influenced by moves in the Federal Reserve's overnight benchmark federal funds rate, interest rates on longer-term Treasury bills also move on their own. They are influenced by several factors or expectations including the current state of the economy, demand for lower-risk returns, supply and demand of Treasury bills, monetary policy, and inflation expectations.
For example, inflation is expected to rise in 2021 as the economy recovers and with all of the government stimulus being injected into the economy. When inflation gets too high -- and the purchasing power of money goes down -- the Fed tends to raise interest rates to slow the economy down and bring down inflation.
I'm not saying that inflation is going to get high enough any time soon to warrant a rate hike, but the prospect of inflation growing significantly in 2021 further supports that there will be a rate increase or increases in the long term. Remember, while the fed funds rate does not control long-term rates, it does influence them, so expectations of growing inflation will push up yields on the 10-year Treasury note. That's just one example, but hopefully it gives you an idea of how certain economic factors can move longer-term interest rates.
How it affects bank stocks
The rising interest rate on the 10-year Treasury note is steepening the yield curve, which is the spread between yields on shorter-term Treasury bills like the two-year Treasury note and longer-term ones like the 10-year Treasury bill. Steepening of the yield curve is positive for banks because it means the gap between shorter-term and longer-term debt is widening.
The yield on the 10-year note has increased to above 1.1%, while the yield on the two-year note has stayed flat below 0.10%. As you can see in the chart below, this has pushed the spread between these two rates as high as it's been since mid-2017.
Image source: FRED economic data.
This is great news for banks because it means they can borrow short-term money very cheaply and then loan that money out long term at a higher rate, thereby increasing their profit margins. A big way that banks make money is on the spread between what they make on interest-earning assets such as loans and what they pay out on interest-bearing liabilities such as deposits.
The interest rate on the 10-year Treasury bill directly impacts mortgage rates, which hit an all-time low earlier this year. So, as mortgage rates come up, banks will be able to charge a higher interest rate on a lot of their mortgage loans, while continuing to keep the cost on the borrowings and deposits funding those loans cheap.
Continuing appreciation
Even with the recent rally in the 10-year note, the yield could continue to grow in 2021. Citigroup recently projected that the yield on the 10-year note could hit 1.2% in coming months and 1.45% by the end of 2021. This should benefit the banking sector, which is already positioned as a value play in 2021. Overall, keep an eye on how the yield on the 10-year Treasury note trends and how much analysts see it growing to gauge where bank stocks might go as well.
