The yield curve is an indicator of future interest rates, which are indicators of the economy’s expansion or contraction.
The yield curve is a line that plots the interest rates or yield values, at a set point in time, of Treasury securities (bonds) having equal credit quality, but differing in maturity dates. Currently the U.S. Department of Treasury reports 1, 3 and 6 months and 1, 2, 3, 5, 7, 10, 20, and 30 year bonds. The most common type of yield curve plots are Treasury securities because they are considered risk-free and are thus a benchmark for determining the yield on other types of debt.
The curve is used to predict changes in economic activity and interest rate change. There are three main types of yield curve shapes: normal, inverted and flat (or humped).
Normal Yield Curve
A normal yield curve is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time. Normally the yield curve is upward sloping showing that, all else being equal, a bond with a longer maturity pays a higher yield than the same bond with a shorter maturity. From the great depression through to today, the yield curve has spent the majority of its time in the shape of a normal upward sloping curve.
Inverted Yield Curve
An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields. An inverted yield curve, particularly a sharply inverted curve, is often followed by economic slowdown—or an outright recession —as well as less future demand for money and lower interest rates along all points of the yield curve.
Flat or Humped Yield Curve
A flat (or humped) yield curve is one in which the shorter- and longer-term yields are very close to each other, this is generally a sign of a pending, or ongoing economic slowdown and that investors are unsure about future economic growth and inflation. Historically, economic slowdown and lower interest rates (and thus an inverted curve) follow a period of flattening yields.
THE STEEP YIELD CURVE
The slope of the yield curve is also important: the greater the slope, the greater the gap between short- and long-term rates. A steep positive curve may indicates that investors are expecting strong future economic growth and higher future inflation (and thus higher interest rates). If interest rates are predicted to rise in the future, investors will demand a higher rate of return when buying longer term bonds. If the longer term bonds are not paying a higher rate of interest , investors will just buy shorter term bonds. Often times, when the economy is coming out of a recession, future interest rate expectations will increase. This is because economic recoveries are normally accompanied by corporations wanting to borrow more (for investment) which increases the demand for money, putting upward pressure on interest rates.
Since 1990, a normal yield curve has yields on 30-year Treasury bonds typically 2.3 percentage points (also known as 230 basis points) higher than the yield on three-month Treasury bills, according to data from the U.S. Treasury. When this “spread” gets wider than that—causing the slope of the yield curve to steepen—long-term bond investors are sending a message about what they think about economic growth and inflation.
A steep yield curve is generally found at the beginning of a period of economic expansion. At that point, economic stagnation will have depressed short-term interest rates, which were likely lowered by the Fed as a way to stimulate the economy. But as the economy begins to grow again, one of the first signs of recovery is an increased demand for capital, which many believe leads to inflation. At this point in the economic cycle long-term bond investors fear being locked into low rates, which could erode future buying power if inflation sets in. As a result, they demand greater compensation—in the form of higher rates—for their long-term commitment. That’s why the spread between three-month Treasury bills and 30-year Treasury bonds usually expands beyond the “normal” 230 basis points. After all, while short-term lenders can wait for their T-bills to mature in a matter of months, giving them the flexibility to buy higher-yielding securities should the opportunity arise, longer term investors don’t have that luxury.
TREASURY YIELD Curves PREDICTED THE 2008and 2001 Recessions
In January 2006, the yield curve started to flatten. This meant that investors did not require a higher yield for longer term notes. On January 3, 2006 the yield on the 1-year note was 4.38%, a bit higher than the yield of 4.37% on the 10-year note. This was the dreaded inverted yield curve. It predicted the 2008 recession. In April 2000, an inverted yield curve also predicted the 2001 recession. When investors believe the economy is slumping, they would rather keep the longer 10-year note than buy and sell the shorter 1-year note, which may do worse next year when the note is due.