For investors in fixed-income securities, yield and interest rates are critical drivers when making investment decisions. If you follow the bond markets, you’ll no doubt hear mention of the yield curve and its slope. But what are they, and can they provide insight into future interest rates and the overall economy? Let’s explore what the yield curve is and how to interpret the shape of the curve.
Table of Contents
- What Is the Yield Curve?
- What Is the Yield Curve Slope?
- What Drives the Slope?
- What Part of the Curve Matters?
What Is the Yield Curve?
The yield curve graphically depicts the yields on different maturities of debt instruments. It is simply a line plot of interest rates by maturity, providing investors with a visualization of yields and interest rates. If you take all the yields for a given type of interest rate (for example, Treasury rates) and plot them on a line, congratulations! You’ve got a yield curve.
A yield curve plots the yields of different maturity bonds against their corresponding time to maturity, allowing investors to visualize the term premium (or discount) for each maturity. Typically, long-term yields are higher than short-term ones since investors want to be compensated for tying their money up for more extended periods, known as “maturity risk.” Investors also consider potential inflation and any loss of purchasing power over time.
You can plot a yield curve for any fixed-income bond type. For example, you can find curves for Treasury and other government bonds worldwide, municipal bonds, agency bonds, and corporate bonds. If you have access to Bloomberg (either directly or with the help of a broker), you’ll find dozens of curves available.
What Is the Yield Curve Slope?
When we’re talking about yield curves, there’s one term with which you need to be familiar. That is the term “slope.” The slope is the difference between short-term and long-term interest rates on the curve. A common slope measure is the difference between two-year and ten-year Treasury yields, otherwise known as the “2s/10s spread.”
Usually, a yield curve will have higher rates as you move further out the maturity scale. This goes back to the idea of maturity risk that we discussed earlier. We refer to this as a positively sloped yield curve, with longer rates higher than shorter ones.
There are three basic yield curve shapes that you’ll want to know. Each of them depends on the degree of slope in the curve.
Steep Yield Curve
A steep curve happens when you have a yield curve with very high long-term rates compared to short-term rates. As you look at the curve, it looks like a very steep hill that rolls down sharply as you move from long- to short-term rates.
We usually see a steep curve when the market outlook is for stronger economic growth or rising inflation. Investors interpret the higher long-term rates as a sign that the market expects the Federal Reserve to raise interest rates in the future.
Flat Yield Curve
A flat curve occurs when the slope of the yield curve is very narrow, meaning there’s little difference between short- and long-term interest rates. When the yield curve is flat, it may signal that the market expects interest rates to stay relatively stable in the near future.
A flat curve can also indicate that the market is anticipating a period of economic stagnation. The curve generally becomes flat later in the economic cycle as investors expect an economic slowdown or if the inflation outlook is decreasing.
Inverted Yield Curve
An inverted curve is when short-term interest rates are actually higher than long-term ones. It’s a rare occurrence, and it sounds strange since a normal yield curve has higher long rates and a positive slope.
Historically, an inverted curve often occurs before a recession and usually after a period of increased interest rates by the Fed. An inverted curve isn’t a guarantee that a recession is imminent, but it is the market beginning to price in an economic slowdown.
What Drives the Slope?
The yield curve’s slope is constantly changing, ebbing and flowing, and becoming steeper or flatter. So, what determines the shape or slope of the curve? Three primary factors can cause the curve to steepen, flatten, or even become inverted.
One factor is the Federal Reserve’s monetary policy decisions. As the Fed raises or lowers interest rates, and the bond market anticipates and reacts to those moves, it will influence changes in the yield curve. The Fed’s rate decisions primarily affect the shorter end of the curve, usually out to about two or three years.
Another factor that influences the curve slope is inflation expectations. As I mentioned earlier, fixed-income investors will factor in the loss of purchasing power and want to be compensated for that risk. If the market anticipates a higher probability of inflation, then interest rates and the yield curve will adjust to reflect that scenario. And if inflationary concerns are diminished, that will also be taken into account.
Market Supply and Demand
The third factor that can affect the slope is the combination of bond market supply and demand. As bond issuance of different maturities changes over time, and as demand for those bonds fluctuates, it affects the price of the bonds, which in turn drives the rate or yield. As those conditions change, the rates represented on the yield curve will move accordingly, changing the slope of the curve in the process.
What Part of the Curve Matters?
As you might expect, yield curves and slopes get a lot of attention in the bond markets, mainly the Treasury curve. Because of that, it can be easy to get caught up in the latest financial headlines about the 10-year Treasury or other yield indices along the curve.
But here’s something to keep in mind. As you evaluate the curve and its slope, ask yourself – What part of the yield curve matters most to your financial institution?
If most of your institution’s earning assets are no longer than five years in terms of maturity or repricing, then why worry about what the 10-year Treasury is doing? The key is to focus on the part of the curve where your assets (including investments) and liabilities reside and base your asset-liability strategies and investment decision-making on your financial institution’s unique yield curve.
The yield curve is an essential tool for financial institutions to use to make decisions about their investment and balance sheet strategies. By understanding the factors that drive the curve and its slope, investors can better position themselves as market and economic conditions shift.
While no one can predict the future with certainty, by paying attention to how short- and long-term interest rates are changing, community financial institutions can do their best to stay ahead of the curve.