In finance, the yield curve is a curve showing several yields, or interest rates, across different maturity durations for a similar debt instrument. The curve shows risk relationships between shorter term bonds and longer term bonds as relates to the interest rate. Risk refers to the time value of the bond, and by definition, longer duration bonds are considered to have more price risk than shorter duration bonds. U.S. Treasury (UST) securities are closely watched by most traders and are commonly plotted on a graph for visual purposes.

The shape of the yield curve indicates the cumulative priorities of all lenders relative to a particular borrower. Buyers of UST bonds are not concerned about quality risk but are mindful of business cycles that constantly influence the shape of the curve. Rising rates of inflation are normally associated with “tighter” monetary policy and investors are more likely to buy shorter duration bonds as a hedge. However, the reverse is true when economic conditions shift over time. Yield curves are used by economists and traders to help to understand conditions in the financial markets and to seek trading opportunities. The slope of the curve is one of the most powerful predictors of future economic growth, inflation, and recessions.

The different types of yield curves are referred to as Normal, Steep, Flat, Humped, or Inverted. Yield curves are usually upward sloping (Normal) where the longer the maturity, the higher the yield, but eventually flattens out. There are two common explanations for upward sloping yield curves. First, the market is anticipating a rise in rates and may receive a better rate opportunity in the future. The second explanation is that longer maturities entail greater risks for the investor and holding off now seems less risky. However, history tells us that staying in shorter duration bonds can sometimes be as risky as maturity extensions. An inverted yield curve is often a harbinger of recession, a positively shaped curve of inflationary growth, and a normal slope everything in between.

NORMAL YIELD CURVE: This positive slope reflects investor expectations for the economy to grow in the future with a greater expectation that inflation will rise in the future rather than fall. This expectation of higher inflation leads to speculation that the Fed will tighten monetary policy by raising short term rates to slow economic growth and dampen perceived market pressure. However, a normal yield curve has not always been the norm. The past 5 or 6 years has seen an unusual fluctuation in the slope of the curve as this recovery, since 2008, has not responded to excessive monetary easing. International forces, coupled with monetary and fiscal intervention, have had a more than normal influence on the shape of the curve.

STEEP YIELD CURVE: Historically, the 10 year UST yield has averaged approximately 2% above that of the 90 day Treasury bill. In situations when this spread widens, the economy is expected to improve quicker than previously forecasted. This is the type curve that is normally seen at the beginning of a time of “boom” or when stagnation has depressed shorter term bonds. During January of 2010, the gap between the 90 day bill and the 10 year UST widened to 292 basis points, its highest ever. The steep yield curve can be a challenge to investors but the reward for risk extensions can be significant.

FLAT or HUMPED YIELD CURVE: A flat yield curve is when all maturities have similar yields, whereas a humped curve results when medium term yields are higher than either the shorter or longer ends of the curve. These type curves are short lived and send mixed signals to the financial markets. Investors tend to buy shorter duration bonds when the curve is flat or humped.

INVERTED YIELD CURVE: An inverted yield curve occurs when longer term bonds have less yield than shorter maturities. An inverted yield curve generally indicates a worsening economy and the Fed has often suggested that an inverted curve is an excellent tool in predicting recessions. There are many global factors that influence an inverted curve which causes foreign investors to aggressively buy longer term UST bonds. This has been the driving force since late 2014 which has kept longer rates lower than normal. In 1982, investors who bought 30 year UST bonds at 15% when funds were trading in excess of 20%, were rewarded with tremendous gains. This was a dicey time for investors, but by the end of 1984, those that took the risk were the undisputed winners.

PEAK of the YIELD CURVE: The peak of the curve is sometimes referred to as the “sweet spot.” This is the point on the curve where rates are still accelerating but at a decelerating rate. In other words, yields are still rising as maturities are extended but at a lesser rate. The risk versus reward lessens when investing beyond the peak of the curve as the “slide down” effect is not as rapid.

Investors should apply yield curve strategies over a long period of time in an effort to enjoy success. There are times when exogenous forces influence the shape of the curve but economic cycles tend to follow logic over the long term.

Please feel free to share this commentary with anyone who might have an interest in refreshing their memories, as we will likely see yield curve changes over the next several years.

The information contained in these posts is meant for personal consumption. This should not be taken as investment advice or a guarantee of any kind. All posts, content and information contained on this blog is solely the opinion of the author and is subject to errors, omissions and/or changes.