While the economy and stock market are not necessarily the same thing, they tend to play off each other. Having a strong foundational understanding of economics helps you make more well-rounded decisions as an investor. Economists and investors have long looked at economic indicators to predict events like bull markets and recessions (although the government does occasionally spark one of these on purpose). While there is no “foolproof” indicator that accurately predicts the future, the yield curve has been analyzed for decades in an attempt to forecast the future of the economy.
In this article, you will learn what the yield curve is, the different “stages,” and what it means for you as an investor.
Before we continue, Financial Professional wants to remind you that all materials in this article are educational in nature. This article is not investment advice. Always consider your personal situation – and the help of a licensed financial professional – when making any investment decisions.
What Is The Yield Curve?
Before discussing the yield curve, let’s cover what yield is in the first place.
Yield simply refers to the rate of return (or interest) offered by an investment.
A yield curve, then, plots the yield offered by fixed income securities (bonds) of similar credit rating or classification across differing maturities (when the bond pays you back).
The curve that economists and investors pay the most attention to is the Treasury Yield Curve. This measures the yields for the various US Treasury bonds that have different maturities.
The maturities typically listed on the yield curve graph are:
- 1 month
- 2 months
- 3 months
- 6 months
- 1 year
- 5 years
- 10 years
- 20 years
- 30 years
The yield attributable to each bond depends on supply and demand and investor sentiment about current and future economic conditions. If you keep up with financial media, you will notice that the yields for bonds of different maturities are constantly quoted and updated.
As a refresher, when investors buy bonds, the price of that bond tends to go up (supply and demand). When the price of a bond goes up, its yield goes down, because bond prices and interest rates have an inverse relationship.
When investors are optimistic about the prospects of the economy and stocks, they tend to sell bonds and purchase equities. This drives the yields of bonds up.
However, when investors are fearful or apprehensive, they tend to sell stocks and buy bonds, driving yields down.
The Shape of The Curve
As you keep up with the state of the economy, you will constantly hear about the “shape” of the yield curve. The shape refers to the slope of the curve when plotted on a graph.
There are several different shapes that the curve can take on, including:
- Normal yield curve
- Inverted yield curve
- Flat yield curve
While the curve isn’t a perfect indicator of the economy’s future, it does tell us how investors feel about the prospects of the economy. Each shape tends to tell its own story, though the underlying data may be complex.
We will discuss that next.
Normal Yield Curve
Under normal circumstances, the yields offered by shorter-term bonds will be lower than that of longer-term bonds.
Typically, bonds that have longer terms offer higher yields to compensate investors for the larger level of interest rate risk they are taking on.
On the other hand, shorter-term bonds have lower interest rates attached to them because they are not subject to the same level of risk as bonds that have longer maturities.
This is what a normal yield curve looks like. Notice now the yield increases with maturity. Economies that are currently expanding, within reason, tend to have a normal curve.
This means that investors are appropriately rewarded for the risk they are taking with longer-term fixed income securities.
Typically, investors are more comfortable with owning equities in this scenario because they believe in the economy’s ability to continue to expand.
Inverted Yield Curve
When the curve starts to invert, or has inverted, it is not a great sign for the economy. The curve officially inverts when the yield of a shorter-term maturity bond is higher than that of a longer-term bond.
When the yield curve inverts, investors are not properly rewarded for taking on the risk of owning bonds with longer maturities.
For example, if the 10-year Treasury’s yield is 1.5% and the 30-year Treasury’s yield is 1.0%, that portion of the curve has inverted.
There are several reasons why the curve may invert, but it typically is due to a combination of:
- Monetary policy driving up short term interest rates to avoid an overheating economy
- Investors buying up longer-term treasuries because they are afraid of equities
In short, when the short term yield goes up and long term yield goes down, that’s the recipe for inversion.
Here’s what an inverted yield curve looks like. Notice how the yield decreases as the maturity increases.
While the curve may not stay inverted forever, it is usually a period of time where fear is coursing through the economy.
Flat Yield Curve
A “flat” yield curve is the intersection between a normal and inverted yield curve. The curve tends to flatten when an economy is currently undergoing a transition (either improving or worsening). As you can imagine, the yields offered by bonds of different maturities tend to be fairly equal.
Investors tend to be on edge whenever the curve starts flattening because there is still a great deal of uncertainty across the economy. The yield curve may remain flat for some time unless monetary stimulus is deployed or economic activity improves/worsens.
A Final Word
As an investor, you should always be striving to increase your understanding of all of the terms that serve as a gauge of where the economy stands, and where it may be headed.
It’s important to reiterate that inversion is not a perfect indicator of a recession. Part of the yield curve inverted in 2019. And yet, the economy continued to expand throughout the year and the S&P 500 ended with a return of 30% for the year.
That said, many of the recessions that the US economy has experienced have been preceded by the curve inverting. Just keep in mind, correlation does not always equate to causation.
Data on the yield curve is reported daily on treasury.gov, the official site for the US Treasury. You can keep up with rates there, or by following financial media outlets.
As always, do your best to keep your goals and best interest in mind as news comes out that affects the shape of the yield curve. Control what you can control and keep the long term in mind.
Have questions on the yield curve? Let us know!