If you’ve ever flipped on the TV and landed on Bloomberg television or CNBC you might hear them reference the yield curve when talking about the future prospects of the economy. From flattening to steeping, the movements of this mysterious curve seem to be used as a harbinger for the economy. Unless you’re in the finance industry, you would probably benefit from them explaining what the yield curve actually is and why it is widely accepted to use as a sign of things to come.
Government bills, notes, and bonds all have different maturities. From 1 month bills to 30 year bonds, each different maturity commands a different yield, or interest rate. As the time to maturity increases, the yields increase because investors require better rates of return for lending money for longer periods of time. Similar to a bank, if you want to borrow money for one year, the interest rate is lower than if you want to borrow for 30 years. Investors require the same when the government wants to borrow money from them: longer term, higher interest rate.
If you were to plot the current yield for each different maturity on a graph, you would arrive at the yield curve. With time on the horizontal axis and the yield on the vertical axis, it’s apparent that as time increases, the yield should too. The result is an upward sloping curve that ideally forms the ‘normal’ yield curve.
The image above is what the yield curve should look like given normal economic conditions. Any divergence from this standard curve can be used to interpret anything from inflation expectations to a coming recession. When the curve becomes flatter it means that the difference between short term and long term yields is becoming smaller. There can be two causes for this; either short term yields are increasing faster than long term or long term rates are decreasing faster than short term. The changes in these rates represent the increasing relative return required for short term investment or the decreasing relative return investors require for long term investment.
Going even further than a flattening yield curve, the curve itself can become inverted. When short term yields are higher than long term yields, it indicates that investors fear the future prospects of the economy and are willing to take a low return over the long term, rather than risk a higher return over the short term wherein the bond could mature during a downturn in the economy. The expectation is that when you have to reinvest during the downturn, the yields available will be even worse than the rate that the long term investor received when the curve was inverted. The ability to see how investors are weighing the near term versus the long term is why the yield curve and debt markets are sometimes looked at as the canary in the coal mine for the economy.
Currently the yield curve is trending towards a flattening. The graph below is the the actual yield curve for U.S. government debt.
As you can see, the actual yield curve is much flatter than the normal yield curve shown in the previous image. When looking at the flattening or steeping of the curve, it is important to remember that it is an indicator, not a guarantee. If what we learned above is true however, the flattening of the curve is at least a troubling sign for the economy.
The yield curve is only one piece of information and should not be looked at in isolation. When one considers GDP growth, an inflation rate that is roughly on target and low unemployment, the current picture for the US economy becomes much less clear. In the end, the yield curve is just one of the many pieces of the puzzle that can be used to help form a view on the direction of the economy.
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