Yield Curve

By Kevin Chambers

A yield curve is a graph that plots the interest rates of bonds with the same credit quality but different maturities. The curve is used to isolate the effect of the length of payment on interest rates. The most common yield curve commented on by the financial media is the yield curve for US Treasuries. The US Treasury yield curve is analyzed as a benchmark for interest rates in general. The yield curve shape can also give clues to what investors are expecting in the future.

The interest rate that the Fed controls is called the Federal Funds rate. This is the interest rate that the Federal Reserve charges banks to keep their money with the Fed. Through 2015, 2016, and 2017, the Federal Reserve decided to start raising interest rates.

Changes in the Fed Funds Rate mostly effects interest rates on the low (short) end of the curve. The rest of the yield curve is determined by the open market. It shows what investors are requiring for return based on the amount of time they need to tie up their money.

If you look at the average yields for each treasury maturity from 2000 -2017, the curve is what we would expect to see.

Short-term (3-month) bonds averaged just above 1.5%, while long-term (10-year) bonds averaged 3.5%. There is a positive relationship between maturity length and yield. This is what a ‘normal’ yield curve looks like.

However, from 2000 through 2017 we’ve seen quite a bit of fluctuation in the curve. One of the ways the Fed fights recessionary trends is to lower interest rates. This is something they have done twice since 2000.

Both times were responses to major financial collapses: the dotcom bubble burst in the early 2000s and the mortgage crisis of 2008. After the dotcom bubble, the Federal Reserve raised interest rates fairly soon after. For the 2008 crisis, they have kept them low much longer. Only in the last couple years have the interest rates started to creep back up.

Even though the Fed has increased interest rates for the short-term end of the yield curve recently, the rest of the curve hasn’t followed.

Long-term rates have stayed fairly flat, only increasing slightly. This fact has started to concern many financial analysts. This is called curve flattening. They are worried that the curve might become inverted. Inverted yield curves have preceded the last seven recessions (J.Racanelli, 2017).

An inverted yield curve means that the short-term maturities have higher interest rates than the longer-term. Take a look at the curves from 2000 and 2007.

The other way to visualize the curve is to look at the difference between the yield for the 1 year and the yield for the 10-year bonds. In finance terms, we call this the ‘spread’ between the yields. Now take a look at this chart:

This shows us visually how the inverted yield curves proceed drops in the S&P 500. There is a pattern to notice: The yields flatten, approach zero, then go negative and become inverted. They stay below zero for a few months, then the stock market crashes. Reacting to the stock market, the Fed lowers interest rates on the low-end, which corrects the inversion problem.

So why would the curve invert? It is driven by investors buying bonds. Motivation can be varied, but the bottom line is that they think that short-term yields will drop in the near future. They are happy to lock in the current long-term rates, even though the short-term rates are higher, because the long-term bonds are guaranteed for a longer period of time. For example, the 20-year rates in the two inverted curves we looked at in 2007 and 2000 are both above the average since 2000. So, investors that bought 20-year bonds at that time, got a pretty good deal.

Two Important Reminders:

First, we currently don’t have an inverted curve; it has just been flattening.

Second, not all inverted yield curves are followed by recessions, even if all recessions are proceeded by them. (This is similar to how all squares are rectangles, but not all rectangles are squares.)

That being said, the yield curve is one of the indicators that we follow at Headwater Investments. Our portfolios are built to hold for long periods of time and weather financial storms. For most of our clients who are in retirement, rising interest rates is a great thing. Higher interest rates will push up dividends and interest for their investments. Wouldn’t it be great to be able to get a return for our money just sitting in the bank again? Even if the curve inverts, it won’t necessarily be time to press the panic button, but it is something to be aware of.

Chart Source: U.S. Treasury Department