Day #211: What Investors Should Know About Yield Curves

Last week, I was lecturing to a group of undergraduate finance majors and was amazed by the number of students who didn’t know the current shape of the Treasury yield curve.  I don’t expect everyone to know this, but I do expect it from a student who is months from earning a finance degree.  I decided to capitalize on this ‘teachable moment’.

Why This is Important

So often, the biggest question that students have is “Is this going to be on the test?“  I try to move them to a place where they want to know “Why is this important?”  That, to me, is a far more reasonable question.  I explain that it isn’t enough to be able to memorize formulas and generate numeric answers.  They must be able to explain what those numbers mean — in English.  Further, I tell them that I don’t want them to learn just for me because I will test them and eventually assign a course grade.  Instead, I want them to learn because the concepts are relevant and may have meaning for them later in life.  This brings me back to the Treasury yield curve.  One thing that I tell students is that one of my goals is to give them a greater appreciation for some of the things that they hear on the nightly business report.  The Treasury yield curve is one such topic.  Interest rates are an important factor in financial markets for many reasons.  They affect our borrowing, our investing and the state of the general economy.  In the United States, the Treasury yield curve is a graphic depiction of one of the most important set of interest rates — interest rates related to Treasury securities of varying maturities.  The maturities range from 30 days to 30 years.  Comparing short-term, long-term and immediate-term interest rates can tell us a lot about the current and expected future state of the economy.

Possible Shapes

Plotting interest rates on the Y-axis and maturities on the X-axis on a two-dimensional graph creates a line that can take many shapes.  Most of the time this shape has a gentle, upward slope where 30-year interest rates are higher than 30-day interest rates.  Because this is the most common shape the yield curve takes, we call this the normal curve.  If 30-year rates are higher than 30-day rates by more than 3%, we would consider that shape to be steep as long-term securities are paying a significant premium over short-term securities.  If 30-year rates are lower than 30-day rates, this is an unusual situation.  Because this is rare, we call this shape inverted.  Finally, if 30-year rates are about the same as 30-day rates, the shape of the yield curve is considered to be flat (or humped if there is some variation in intermediate-term rates).

What the Shapes Mean

Based on economic theory, as well as historical evidence, the shape of the yield curve tells us a lot about what we might be able to expect in the future.  A normal yield curve indicates that the economy is expected to grow at a normal rate over the foreseeable future without extraordinary inflation.  This is the ideal situation.  A steep yield curve indicates that the economy is expected to improve soon and may even signal an expansion (the next phase after a recession).  This happens because current conditions force short-term interest rates to remain low but optimism about the future causes investors to start driving longer term rates up through increased demand.  By contrast, an inverted yield curve effectively tells the opposite story.  Pessimism about the future drives longer term interest rates below short-term interest rates because of a lack of demand.  A flat curve can either mean that the economy is transitioning from a stable state to a weak state or that there is considerable uncertainty about the future.

The Current Treasury Yield Curve and What it Means for Investors

Right now, long-term interest rates are more than four percentage points higher than short-term interest rates.  Therefore, the current shape of the Treasury yield curve is steep.  This is a strong indication that the economy is entering an expansion and that the recession is over.  Some people mistakenly think that this yield curve business is only meaningful to bond investors.  Not true!  The Treasury yield curve is an economic indicator.  A transition from a recessionary time to one of expansion is big news for all investors — and even non-investors.  It means that the stock market (another economic indicator) should be strong in the future.  It means that consumer confidence and therefore spending should increase.  This should lead to lower unemployment.  Therefore, if you are an investor who has been sitting ‘on the sidelines’ waiting for a good time to re-enter the market, now (or at least very soon) might be the time.

OK.  The economics/finance lesson is over, but just think of how you can impress your friends at your next cocktail party!

Leave a Reply

Your email address will not be published. Required fields are marked *