With interest rates front and center these days, I thought we would take some time to explore the yield curve and some of the information that can be gleaned from it. The yield curve represents the relationship between interest rates on bonds of different maturities, but equal credit quality. For our purposes, we’ll be discussing the US Treasury yield curve.
The slope of the yield curve has proven to be a good forecaster of economic growth. There are three basic shapes the yield curve can take, each with different implications regarding economic growth. We’ll explore these below and then take a look at the what the current yield curve is saying.
A normal, upward sloping yield curve. This is how the yield curve looks when an economy is growing and investors are confident. In a growing economy, investors demand additional premium (yield) for longer maturity bonds. This is logical considering there is more risk associated with having money tied up for longer periods of time. Healthy economies nearly always have an upward sloping yield curve, although the interest rates that make up that curve may differ substantially from one period to another.
A flat yield curve indicates that investors are not being compensated for the additional risk of longer maturity bonds. This is a warning sign that an economy is under duress; investors expect slow growth, and economic indicators are sending mixed signals. As investors buy and sell bonds to flatten the yield curve, they are demonstrating through their behavior that they are worried about the outlook of the economy. As a result, they prefer to have their money tied up longer in safe investments, and demand less of a return for doing so.
A flat yield curve can develop into the dreaded “inverted” yield curve when the economic outlook is very bleak. When the yield curve inverts, it indicates tough economic times ahead. The logic goes like this: If I’m worried the economy is going to crash, I want to look for safe ways of preserving my capital. If I suspect falling equity prices, and falling interest rates, I’m going to try to lock my capital away in longer-term bonds as a way to ride out the storm. As more and more investors do this, it drives longer maturity bond prices up, and the yields down. These same investors will shy away from short-term bonds, which may have to be reinvested during the downturn. This lack of demand drives short-term treasury prices down and the yields up.
There are multiple ways to analyze the slope of the yield curve, so which is the most accurate? Statistically, the method that has shown the most reliability in predicting future economic growth has been to look at the difference between the rates on the 10-year Treasury Note and the 3-Month Treasury Bill. When the yield on the 10-year is greater than the yield on the 3-Month, the slope is positive, and when this relationship reverses (3-Month rate greater than the 10-Year rate), the slope is negative and the yield curve is considered inverted.
Source Financial Sense