In the simplest definition, bonds are debt instruments. When a government or company needs capital, it issues bonds. By buying these bonds, an investor is essentially lending money to the issuer, and in return, receives a periodic interest payment (a coupon) and gets their principal back at maturity. Among all the bonds in the world, U.S. Treasury bonds are known as the safest financial asset on Earth, since they're backed by the economic and military power of the U.S. government.
Key concepts: price and yield
Understanding trader behavior requires knowing two variables: the bond price, meaning the price at which a bond is bought and sold in the market; and the yield, meaning the rate of return an investor earns from holding the bond until maturity. The golden rule of bonds is that bond prices and yields always have an inverse relationship with each other; when demand to buy bonds rises, prices rise and yields fall, and vice versa.
Why do traders watch U.S. Treasury yields so closely?
The yield on the U.S. 10-year Treasury bond is the market's main compass. The first reason is that it's a risk-free rate and pricing benchmark; if an investor can earn a 5% return with zero risk from government bonds, they'll only be willing to put their money into risky markets if they see the potential for a much higher return. The second reason is that it's a gauge of inflation expectations and Federal Reserve policy; rising yields signal expectations of rising inflation or interest rate hikes, and falling yields signal an outlook of falling inflation or a coming recession. The third reason is the cost of borrowing worldwide; the 10-year Treasury yield directly sets mortgage rates, credit card rates, and corporate loan rates around the globe.
The effect of bond yields on different markets
Gold pays its holder no return or coupon whatsoever; when bond yields rise, the opportunity cost of holding gold increases, because investors prefer to sell gold and buy risk-free bonds with a high return, so the relationship between bond yields and gold is usually inverse. Rising yields act like a brake on stocks and Bitcoin, because on one hand it raises companies' borrowing costs, and on the other hand it redirects liquidity toward risk-free bonds; falling yields are the main fuel for bullish rallies in stocks and crypto. In the forex market, bond yields have a direct relationship with the appeal of a national currency; when U.S. yields rise relative to other countries, global investors convert their money into dollars to buy American bonds, which strongly strengthens the dollar.
The yield curve and recession-forecasting signals
One of the most important uses of bonds is examining the yield curve, which compares the yield on short-term bonds (say, 2-year) with long-term bonds (say, 10-year). Under normal conditions, the 10-year yield should be higher than the 2-year yield, since holding money for longer carries more risk. But if the 2-year yield rises above the 10-year yield, what's called a yield curve inversion occurs; history has shown that this inversion has been the most accurate recession-forecasting signal in the United States over the past fifty years.