What is the yield curve?
The yield curve is the current graphical representation of prevailing interest rates of fixed-interest securities over varying lengths of maturity. This means that each point along the yield curve is a market price, expressed as a yield (interest rate), for a bond (fixed-interest security) with a stated time to maturity. In effect, the yield curve communicates the average return to maturity the market requires for bonds of varying maturities. If an investor holds that security to maturity they expect to receive the stated rate of return.
The most commonly quoted yield curve is that of U.S. government issued fixed-income securities, commonly referred to as treasuries. A reason for this is that the U.S. treasury yield curve is often used as a benchmark for various other debt throughout the U.S. economy. Lenders are tied to the yield curve when determining much of their own prevailing rates, as they have a market rate from which to compare and create a spread. With so much of our economy tied to credit and money exchanging hands between borrowers and lenders, the yield curve can provide a great deal of insight to help predict forward looking economic trends and conditions.
Breaking Down the Curve
Now that we’ve conceptually introduced the the yield curve, let’s define how to read it when it’s actually presented to us or we are faced with economic data.
As is visible from the graphic above, the yield curve is most commonly presented with yield along the y-axis and maturity along the coordinate plane’s x-axis. At lower maturities, a “normal” yield also remains low, while as we move forward along maturity the y-axis value also increases. Therefore, while a shorter-term arrangement may demand an interest rate of X%, the same borrower could pay X+2% for a longer-term loan. The most obvious reason for this is that the lender requires additional compensation via higher interest rates to comfortably assume a longer a loss of liquidity of their funds as well as accepting a risk of potential default. Conceptually, this makes sense as there is a risk premium that lenders require to be compensated the longer their capital is loaned out or tied up, generally speaking.
Note that while the relationship between maturity and yield is positively correlated, it is far from a linear relationship at many points. As we move further along the curve, the premium in yield that is required for each additional unit of time (risk) decreases until the curve begins to flatten out. Therefore, some places along a yield curve are considered to be “steeper” than others and may present more or less attractive investment opportunities as a result.
Trouble with the Curve
Once we understand the basic relationship between maturity and rates we can begin to make sense of what implications the status of a given yield-curve may have on broader economic conditions.
Normal Curve: The earlier graph above assumes a relatively normal yield curve, indicating that present borrowing conditions throughout the economy are relatively stable, ordinary. This also tends to mean generally favorable macro-economic conditions are present throughout the economy, and to some may indicate that at a minimum we are not entering or currently in a recessionary environment. As longer-term yields continue to rise or stabilize comfortably over their short-term counterparts the economy is generally considered to be expanding or at least healthy. The movement in this curve is the same as in any economy and will move based on the supply and demand along various points in the curve. Higher demand can drive prices up while pushing yields down at a given point.
Inverted Curve: When the yield curve’s longer-dated maturities begin to have decreasing yields associated with them while lower yields remain level or increase, an inverted curve will exist once long-term rates intersect short-term rates. Specifically, once the 10-year yield inverts to a lower rate than the 2-year yield, many economists believe this is a key indicator to suggest a recession within the next six to eighteen months (other economic factors not considered). One scenario in which this plays out is when the prevailing longer-dated interest rates appear to be at lower, more attractive rates for certain buyers/borrowers or short-term rates are artificially raised but a corresponding rise in long-term rates doesn’t follow.
Flat Yield Curve: A flat curve is when the rates are relatively flat along nearly all maturities. This is rare and generally is merely a point of transition between normal curves or inverted curves rather than a sustained state for any materially long period of time. On a macro-economic level it is considered to be indicative of a transitioning economy.
Where are we today?
As of the end of 2018, the spread between the 10-year and 2-year US Treasury narrowed to within positive 20 basis points. This means that if the spread tightened another 20 basis points, this portion of the curve would officially be flat or potentially inverted. As of late February 2019, this spread remains relatively consistent with where it was at the end of 2018 (16 basis points at the time of this writing).
Based on the current state of the yield curve, macro-economic indicators would suggest that a recession is not imminent. However, following late 2018’s rate hike, the increasingly tight spread between the 10-year and 2-year yields did occur as a result of the Federal Reserve’s actions. Thus far in 2019, the Federal Reserve has decided not to engage in another round of rate increases so far, which has been a temporarily encouraging sign to many investors. However, we should take caution that a recession could be possible at some point in later 2020 or thereafter considering that the curve is so close to inverting and what this indicator has traditionally meant for broader macro-economic conditions. Once inversion occurs, it can be expected that the Federal Reserve will begin cutting rates or at a minimum cease raising rates if nothing else changes on the far end of the yield curve.
What to make of it all?
It’s great to understand the curve and where we stand, but what is one to do about it when investing? We can’t prevent a recession from occurring - that is for certain. However, while it is impossible to predict which direction rates will move for a given security, investors should remember that curves around the world are not perfectly correlated. This is not a US-exclusive metric and there are over 10 other significant economic yield curve indicators worldwide each with their own differences in expected returns. By investing in products that give exposure to yield curves and securities around the world, investors are able to minimize the volatility associated with future curve movements. This is diversification and simple hedging at work. While we can know the current yields for various terms, it is near impossible to accurately anticipate for certain which way the curve moves going forward until it actually occurs.
Investors exposed to credit and other fixed-interest strategies need to properly understand their risks and how a strategy considering changes in interests rates impacts their portfolio. Equity investors have historically been able to capture upside in the stock market for a short while even after a curve inverts. Further, the risks inherent in a portfolio that has a level of correlation to yield curve movements should be appropriate with the investor’s broader wealth planning goals. Investors with questions about the yield curve, fixed income investing or the broader economy and markets should consult their qualified professional advisor. Please contact us at Hudson Oak Wealth if we may be helpful in further discussing or explaining any of these concepts.
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