Understanding the Yield Curve
The yield curve is a financial tool that shows how interest rates change depending on the length of time until a bond matures.
Generally, when economists and analysts refer to the yield curve, they usually refer to US Treasuries, which are considered safe investments. The maturity dates of these Treasury bonds vary: 3-month, 2-year, 5-year, 10-year, and 30-year.
Analyzing the yield curve gives investors a snapshot of market sentiment regarding the present and future state of the economy. Because of this, the yield curve is an invaluable tool that investors can use to make informed decisions.
Yield Curve Shapes
The shape of the yield curve can vary, each providing its own market insight.
Normal Yield Curve
A normal yield curve slopes upward, which means long-term bonds offer higher yields, or more returns, than short-term bonds. This makes sense because investors expect to receive more returns for committing their money for a longer time. In an environment like this, economic growth is expected to remain strong with the potential for future higher inflation.
Steep Yield Curve
A steep yield curve occurs when long-term interest rates are rising faster than short-term rates. This suggests strong economic growth and the potential of increased inflation due to rising demand.
Downward Sloping or Inverted Yield Curve
An inverted yield curve happens when short-term interest rates are higher than long-term rates. The downward sloping yield curve is traditionally thought of as a recession indicator, and an inverted curve has proceeded each of the last 10 US recessions.
However, the reliability of the curve as an indicator of an impending economic recession has been questioned recently. Since COVID, the US 10-year and 2-year bonds have experienced periods of inversion while the economy continued to improve, as measured by stronger GDP figures and low unemployment. Former US Federal Reserve Chair Janet Yellen has publicly voiced her doubts regarding the yield curve as a recession indicator, stating there is a “historically strong correlation between yield curve inversions and recessions, but correlation is not causation” (Chen, n.d.).
Flat Yield Curve
The flat yield curve occurs when short-, medium-, and long-term bond interest rates are essentially identical. Historically, a flat curve does not signify any particular market and instead indicates broad uncertainty regarding the economic future (Segal, n.d.).
Humped Yield Curve
In the humped curve, medium rates exceed short- and long-term rates. Economists regard the humped curve as a potential sign of a cyclical change, with an expectation that the Fed will soon adjust short-term rates as a response to shifting economic conditions (Segal, n.d.).
Curve Movements
In addition to the shape of the curve, the way it moves is just as important as the result. There are four primary movements that economists follow:
Bull Steepening
A bull steepening occurs when short-term rates are falling faster than long-term rates, normally due to expansive Fed policy. Investors typically view a bull steepening as a positive sign for the economy and a short-term bullish indicator for the stock market.
Bear Steepening
A bear steepening indicates that indicates short-term rates are rising faster than long-term rates. A negative market signal, the bear steepening signals the market’s expectation of rising inflation (Hayes, n.d.). To combat inflation, the Fed may raise rates on the short end, which causes prices on long maturity debt to fall. If the price of longer dated bonds falls faster than the rise in short-term yields, the overall term structure will steepen.
Bull Flattener
A bull flattener may result from the market forecasting lower inflation (Waring 2015). Therefore, traders move into longer dated securities, which results in long-term interest rates falling faster than short-term rates. The bull flattener is a positive signal for the economy because it frequently precedes a more dovish Fed position and stronger future market returns.
Bear Flattener
In a bear flattener, the short-term yields increase quicker than long-term yields. Market participants are anticipating a more hawkish Fed, meaning an increase in rates, which is bearish as it is usually a response to an overheating economy and/or rising inflation (Hayes, n.d.), which could slow down the economy.
Why Does the Yield Curve Matter?
The yield curve is an important forward-looking gauge of market health. It provides a snapshot of market sentiment and expectations for the economy. Historically, the shape and movement of the curve have been important predictors of future economic conditions and stock market performance.
However, the reliability of the yield curve as a market barometer has been questioned lately, as recent, continued curve inversions have yet to be followed by a recession. Other global economic conditions and monetary policies from the Federal Reserve can also influence the curve. So it’s important to consider it along with other economic indicators.
What the Yield Curve Means for You
For investors, understanding the yield curve can be a helpful tool for gauging market sentiment, predicting economic trends, and making more informed decisions. While it's not a perfect predictor, it does give us a sense of how investors are viewing the economy. Whether you’re buying bonds, stocks, or other assets, keeping an eye on the yield curve can provide valuable insights into the direction of the markets.
To learn more about the Yield Curve and how it can support your investment strategy, please reach out to one of Avrio’s trusted wealth planners.
Sources:
Chen, James. n.d. “Term Structure Of Interest Rates Definition.” Investopedia. Accessed November 8, 2024. https://www.investopedia.com/terms/t/termstructure.asp.
Dhanraj, Christopher. n.d. “What the Yield Curve Can Tell Equity Investors.” Accessed November 8, 2024. https://www.advisorperspectives.com/commentaries/2018/02/05/what-the-yield-curve-can-tell-equity-investors.
Hayes, Adam. n.d. “Bull Steepener: Making Sense of This Shift in The Yield Curve.” Investopedia. Accessed November 8, 2024. https://www.investopedia.com/terms/b/bullsteepener.asp.
Segal, Troy. n.d. “The Predictive Powers of the Bond Yield Curve.” Investopedia. Accessed November 8, 2024. https://www.investopedia.com/articles/economics/08/yield-curve.asp.
Waring, David. 2015. “Bull Flattener, Bear Flattener, Bull Steepener and Bear Steepener Explained.” LearnBonds.Com. February 18, 2015. https://learnbonds.com/bull-flattener-bear-flattener-bull-steepener-and-bear-steepener-explained/.
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