What is the Yield Curve?

November 16, 2017

If you follow financial news, you’ve probably
been hearing a lot about the “flattening yield curve.” There’s no shortage of
punditry, analysis, and interpretation in the many articles on this topic (like this or this). We even touched on the matter is our most recent newsletter. But 
what does it mean when the yield curve
flattens – and why does it matter?

For the uninitiated, a “yield curve” is a visual
representation of the relationship between the effective interest rates
(yields) associated with U.S. Government Bonds (“treasuries”) of different
maturities (which range from short term to long term). For example, the yield
curve for treasuries currently looks like this:

blogimages/yieldcurve https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/Historic-Yield-Data-Visualization.aspx

As you can see, the longer the maturity – the
higher the yield. Many of us are familiar with the same phenomenon in the
context of shopping for mortgages. Rates on 30-year mortgages tend to be higher
than 15-year rates. Why? Lenders view it as riskier to lock in interest rates
for a long time – and will increase rates accordingly. The result? An “upward sloping” yield curve in which long term interest rates are higher than short term rates.

Alas, the only constant is change; bond yields
continuously respond to investor behavior. If investors engage in a bidding war
for treasuries, their price is driven up by demand. As a result, consumers pay
more dollars for the same interest payments. The effect is a diminished yield:
a lower effective interest rate on invested dollars. Depending on economic
conditions, short- and long-term yields sometimes rise and fall in different
measures at the same time, which can impact the shape of the yield curve. Economists
and market watchers observe the slope of the yield curve as a proxy for market
sentiment, trends, and economic conditions.

When the upward slope of interest rates
increases, the yield curve is often referred to as “steepening” as long-term
interest rates rise faster (or fall slower) than short term rates.  Recently, we’ve observed the opposite effect
– the “flattening” yield curve.  For
example, the 10-year treasury yield has declined slightly this year. Meanwhile,
we’ve seen a significant increase in short term interest rates, which has
resulted in little difference between short and long term borrowing costs. Thus,
a flattened yield curve.

Investors typically view a flattening yield
curve as an ominous sign. Consider an example: Joe Investor buys a 10-year
treasury for a 2% yield. On the same day, he had the opportunity to buy a
3-year treasury for 1.8%. Joe likely expects that interest rates will be
falling – and that in 3 years, when the short bond matures, the yields
available in the marketplace would be less attractive. Thus, he’s willing to
lock into a significantly longer-term investment with little yield incentive to
do so.

In extreme cases, the yield curve can become
“inverted.” Investors are so skeptical of the current interest rate environment
that they will accept lower long-term
interest rates over higher short-term opportunities. Inverted yield curves are
rare; a persistently inverted yield curve has only occurred three times in the
last thirty years. In each instance, broader interest rates declined, and the
economy fell into recession in short order.


The yield curve today has been flattening and exhibits
below average steepness, but it is not inverted.  There are two primary theories as to why this
is occurring:

  1. The economy cannot grow at the rate that it did prior to the financial crisis due to the demographic trends, high debt levels, and limited potential for productivity growth. The current cycle of rising interest rates will end relatively soon.
  2. Interest rates overseas are much lower than in the United States. Demand from international investors may be artificially suppressing long term interest rates in the U.S. (remember: higher bond prices make for lower yields).

We’re hopeful that a recent rebound in the value of the US Dollar supports the case for option #2 above. that said, economic expectations have risen significantly in the past year; while productivity growth from new technologies may eventually allow for higher interest rates, we are wary of the risk that economic growth could disappoint in the short term and make option #1 a reality.

For the moment, the flattening yield curve is one of the only economic indicators that is pointing to trouble ahead. It is also only one of the many indicators that is used in developing a market outlook and investment strategy. Nevertheless, we’ll be watching the yield curve closely over the coming weeks, months, and years.

Any questions? Contact us and let us know.

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