The Yield Curve: What You’ve Always Wanted to Know but Were Afraid to Ask

Have you always wanted a crystal ball to tell you where interest rates are headed? Look no further than the yield curve.

In another installment in our Derivatives 101 series, we’ll take a look at an often misunderstood topic that’s thrown around the financial news headlines on a daily basis. How much do you really understand about the Yield Curve? Read on and be the most interesting person at the cocktail party.

What is a Yield Curve and Why Should I Care?

The yield curve is a line that plots the annual interest rates paid on bonds of various maturities, typically ranging from one month out to 30 years. The line or “curve” is a snapshot of interest rates, referred to as “yields” at a set point in time. Yields on longer-term bonds, say 10+ years, tend to be higher, reflecting the risk the purchaser of the bond incurs in holding it to its maturity. The primary risk to bond holders is inflation, and its ability to erode the value of the fixed payments or “coupon” the bond pays to its owner over time. Bondholders hate inflation, and will often bail out of their bond investments at any hint of it in pursuit of other, inflation-friendly investments, like stocks.

Economists and the Fed routinely examine the yield curve for clues on what the market is thinking about  growth and inflation. It’s an important tool for determining where interest rates are likely headed in the future (that’s why you should care). One of the most commonly analyzed yield curves is that of US Treasuries.

Interpreting the Curve

Analysts look at the yield curve’s shape or “slope” for insights into future interest rate changes and economic performance. There are four main types of yield curve shapes:

Rising, aka “Normal”

• What it is: A curve in which longer maturity bonds have a higher yield than those of shorter maturity.
• What it means: Due to the uncertainty related to time, a rising yield curve illustrates investors demand a higher return (yield) on longer maturity bonds over those of shorter maturities.
• Implications for the future: Indicates that longer-term interest rates may rise, as a direct response to economic expansion. Investors demand an increasing return from their bond holdings when faced with other, high return alternatives which exist in an economy that’s growing at a healthy pace.

Steep

• What it is: A more extreme version of the rising yield curve above, a steep yield curve is one in which long-term interest rates are significantly higher than shorter term ones, making the curve appear “steeper”.
• What it means: A rising yield curve becomes steep because bond holders expect rapid economic growth, rising inflation, and higher interest rates in the future.
• Implications for the future: A yield curve steepens because of a high likelihood that the Fed will, or already has, begun raising interest rates to combat the looming, corrosive effect of rising inflation.

Inverted

• What it is: A curve in which longer maturity bonds have a lower yield than those of shorter maturity.
• What it means: Suggests yields on longer-term bonds may continue to fall, corresponding to economic recession, as investors seek the safety of an investment that pays a fixed payment, choosing to purchase the bond before yields fall even further.
• Implications for the future: Indicates a high likelihood that the Fed will, or already has, begun cutting interest rates to offset a looming economic slowdown.

Flat

• What it is: A curve in which longer-term maturity bonds have a similar yield to those of shorter maturity. A transitory state of a yield curve, which could manifest from either the Inverted or Rising curve outlined above, as the difference in long-term and short-term yields decreases.
• What it means: Suggests falling expectations of inflation in the future. As described above, investors demand a higher return from longer maturity investments due to the uncertainty of time. When inflation becomes less of a concern, investor’s demands for higher long-term yields wanes.
• Implications for the future: Indicates an anticipation of lower inflation and slower economic growth. Sometimes, the yield curve flattens because short-term yields rise near the level of long-term yields because of the expectation the Fed will raise interest rates soon.

What the Yield Curve for US Treasuries looks like right now and what it implies (crystal ball):                                                                                                                                                                      Source: US Treasury

The chart above shows the Treasury curve at two points in time; now (green) and one year ago (purple). We can see that the Treasury curve has flattened slightly over the last year, that is, short term interest rates have increased while longer term ones have decreased. While the curve is still definitely “normal” (short term interest rates being much lower than longer term ones), the difference in short and long term rates has decreased somewhat over the last year. So what’s it mean?

• The market’s expectations of a Fed rate hike have increased. When the Fed hikes or cuts interest rates, it does so by changing a short-term interest rate. If you hold short -term bonds in your portfolio and expect the Fed to hike soon, the value of your short-term bond holdings will fall as a result of the Fed’s increase in short-term rates. To prevent taking that loss, you’ll sell your short-term bonds, reducing their price and increasing their yield in bond markets. This activity is witnessed by market observers via a rise in short-term yields.
• The market expects longer-term interest rates to rise as a direct response to expectations of continued economic expansion,  just not as much as a year ago. As indicated by the “normal” shape of the current curve, and despite higher short-term yields, investors still demand an increasing return from their long-term bond holdings, its just that the degree of yield they’re demanding has decreased.

Factors that Influence the Yield Curve

Bond prices and yields move in opposite directions, and different factors influence movements on either end of the yield curve. Short-term interest rates, a.k.a the “short end” of the curve, are heavily influenced by expectations of the Federal Reserve’s future monetary policy decisions. Short-term rates rise when the Fed is expected to raise interest rates, and fall when it is expected to cut rates.

Longer-term interest rates, a.k.a the “long end” of the curve, are also influenced by the outlook for Fed policy, but other factors play a major role in moving long-term yields around, specifically the outlook for inflation, economic growth and investors’ general attitude toward risk.

Slower growth, low inflation, and investor’s depressed appetite for taking risk cause yields to fall. Conversely, expectations of faster growth, higher inflation, and investor’s increasing risk appetite cause yields to rise. All of these factors push and pull simultaneously to affect the shape of the yield curve and influence expectations of future Fed monetary policy decisions.