Curves Ahead. Interpreting Bond Yield Curves

While it is tempting to think of the yield curve as that length of road before you merge into traffic, in the world of bonds it represents something very different. By definition, the yield curve is a graph of the interest rates of bonds of a similar type across different maturities, for example Treasury yields over one, three, five and ten years. This U.S. Treasury yield curve is one of the most frequently discussed and it has been in the news recently. The Treasury yield curve’s changing shape over the past two years has caught many investors’ attention. A ‘normal’ shaped curve is upward sloping, meaning yields are lower in the short run vs. the long run. In general, investors require a higher yield as compensation for the added risk of buying bonds with longer maturities. Longer term yields also reflect expectations for future economic growth and inflation.

On the other hand, short term yields are more affected by interest rate expectations, and have been increasing as a response to the gradual raising of rates by the Federal Reserve. At the same time, longer term yields have not moved as much, due to lower inflation and growth expectations. This, in effect, ‘flattens’ the curve, resulting in a decreasing spread between the short and long term bond yields. The most closely watched yield spread is the difference between 2-year and 10-year Treasuries. That spread remains positive. However, five-year rates dropped lower than three-year rates last month, for the first time in ten years. They are now also lower than one and two-year rates.

An ‘inverted’ curve occurs when short term rates rise above the long term and is widely thought to be a recession indicator. Inversions reflect investor expectations of slower future growth, low inflation and future rate cuts by the Federal Reserve. In the last 40 years, the yield curve has inverted before every recession. However, note that not every inversion has been followed by a recession. Past recessions have started anywhere from 6 to 24 months after a yield curve inversion. Currently only a small portion of the curve has inverted, and this is generally not the kind of inversion that signals recession. The inversion we see now has occurred numerous times in the past without markets taking notice or scaring investors. It’s important to note that the yield curve is also only one economic indicator and should not be viewed on its own. In the meantime, the fundamentals of the U.S. economy have been mostly positive and we will continue to monitor the macroeconomic environment for warning signs ahead.
 

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