If you're a stock, options, or bond trader, you've probably heard the term "yield curve" and have wondered what it is and if it is significant. The yield curve is a relatively straightforward economic indicator.
We'll discuss the yield curve, its importance in financial markets, and what it means for the economy and you, the investor.
What is the yield curve?
The yield curve is a graphical representation of the yield (interest rate) of bonds with different maturities.
The yield curve typically slopes upward, indicating that longer-term bonds have higher yields than shorter-term bonds. This is because long-term bond yields are a function of longer term growth, inflation expectations, and term premium.
Essentially, it is the added cost borrowers must pay to have lenders agree to tie up their money for a longer period of time.
Shorter duration bonds, such as Treasury bills, are not a function of growth and inflation projections but rather a function of the Federal Reserve and where they set the overnight borrowing rate.
Treasury yield curve
The Treasury yield curve specifically tracks the yields of U.S. Treasury bonds. Financial market participants closely watch the Treasury yield curve because it is often seen as a leading indicator of economic activity.
The relationship between different Treasury maturities, such as 10-year notes versus 2-year notes is closely watched as an economic indicator. An inversion of the "2s/10s spread" is often viewed as an economic recession indicator.
Why is the yield curve important?
The yield curve is significant because it is a strong indicator of economic conditions. If the yield curve slopes upward, it generally indicates an optimistic outlook for the economy. Investors expect interest rates to rise in the future as economic growth expands.
Conversely, if the yield curve slopes downward or is flat, this usually points to a more pessimistic outlook, as investors anticipate lower growth and an increased possibility of a recession.
Inverted yield curve
Typically a yield curve is upward sloping, as investors require a higher yield as compensation for tying up their money for an extended period. The 30-year bond typically has a higher yield than the shorter-term bills because of inflation.
In a healthy and growing economy, inflation will be higher in the future than it is today.
An inverted yield curve occurs when the yields on shorter-term bonds are higher than those on longer-term bonds and is often seen as a sign that the economy is slowing and may enter a recession. Recessions mean lowered growth expectations and lower inflation expectations, thus lower yields.
Regardless of your investment type, the yield curve is essential to understand because of its history of signaling changes in the underlying economy.
Yield curve and the economy
The yield curve can be a helpful predictor of economic growth. A normal sloping yield curve indicates a healthy environment for growth, which means a healthy environment for most asset classes.
An inverted yield curve, where short-term rates are higher than long-term rates, has preceded every recession in the past 50 years. A recession typically lags inversion by 12-18 months.
It is important to note that an inverted yield curve does not always forecast a recession. However, an inverted yield curve has accurately predicted recessions more often than it has failed to predict recessions.
An environment with a normal sloping yield curve is a healthy environment for risk assets. In contrast, an inverted yield curve signals that investors may need to re-think their allocation between stocks and bonds and growth versus value stocks.