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Why The Yield Curve Needs To Stay In Shape

4/28/2015

The yield curve is a line that depicts the rise or fall in a bond’s yields for increasing contract lengths, or maturities. Most commonly referenced is the U.S. Treasury yield curve. Because U.S. Treasury bonds have traditionally been viewed as a risk-free investment, their yield curve represents (to many) the absolute minimal rate for holding debt over a given period.

Understanding the yield curve is beneficial for two main reasons: it is a useful reference when making investment decisions and it serves as barometer for fluctuations in the economy.

How Does The Yield Curve Get It’s Shape?

The typical shape for the U.S. Treasury yield curve is upward sloping from left to right (short-term to long-term). This slope is common across most bonds because, all other things equal, investors will demand a higher rate of return for committing to a longer-term investment.

At times, however, the yield curve has been flat or downward sloping. This is called an inverted yield curve, and is traditionally seen as an indicator that investors expect interest rates will decrease in the future. It is important to note that there are many factors that can influence the shape of the yield curve. Investor demand, expected inflation, borrowing time frame (duration), liquidity, and credit risk are traditionally the largest components of changes to the shape of a yield curve.

U.S. Treasuries’ short-term interest rates are highly influenced by the activities of the U.S. Federal Reserve. Based on the outlook for economic activity, the Federal Reserve determines where to set its federal funds rate – the interest rate at which banks borrow at the Federal Reserve overnight. Since an overnight loan is the shortest (and safest) borrowing time possible, the federal funds rate is often considered the starting point for the yield curve.

Despite its level of control over the shortest-term borrowing, government influence on the yield curve drops as the length of terms increase. It is on the longer term side of the yield curve where the factors mentioned earlier play a larger role. Maintaining an effective balance between monetary policy and prevailing economic forces is often somewhat of an educated guessing game. The goal for The Federal Reserve is to limit big swings in interest rates, ultimately avoiding market crashes and high inflation.

What Does The Yield Curve Mean For Market Movements?

Paying attention to the yield curve and its shape can be important for financial planning. This is especially true when the curve becomes inverted. According to research conducted by many economists, the last seven recessions were all accurately forecasted by inverted yield curves. On average, the last seven recessions occurred within 12 months of the first time the yield curve became inverted.

However, nothing in investing is absolute. Markets are volatile and can be influenced at any time by thousands of outside factors. No market indicator can predict the occurrence, timing, length or degree of an economic downturn. But the yield curve historically has been a great indicator of what market participants think will happen.

Today, it is generally thought that interest rates will increase in the future. The Federal Reserve ceased quantitative easing, it’s massive bond-buying program, at the end of 2014. In and of itself, this means a tightening of liquidity which supports the idea of higher return for a longer term investment. In other words, a normally shaped yield curve.

Interestingly enough, The Wall Street Journal recently reported that the curve reflecting the yield differential between two-year and 10-year U.S. government debt has flattened to 1.40 percentage point from 2.28 percentage points a year earlier. The consensus explanation is that low interest rates internationally, especially in Europe, have investors flooding the U.S. markets. The liquidity that needed to be constrained still exists because of investor demand. For these reasons, the yield curve is one of the most important indicators to monitor in today’s economic cycle.