The yield curve is a tool used to predict the future of interest rate adjustments and economic activity; it is a graph that shows the difference between the return on long term versus short term investments. More specifically, it “is a line that plots yields (interest rates) of bonds having equal credit quality but different maturity dates.” The curve is considered a benchmark for other debt in the market, such as bank lending rates and mortgage rates.
Types of Yield Curves
The yield curve can portray three major, but distinct scenarios, all indicating different predictions for the economy. Let’s review.
1.) Normal Yield Curve: The upward slope indicates that longer term maturities will have higher yields than short term maturities. This is considered the normal yield curve because the longer that you own an asset, the more you will make on said asset. Also, longer term investments are rewarded in this case with better yields than the shorter investments. Some economists also recognize a steep yield curve and identify that an exaggerated curve is a strong indicator that we are at the start of an expansionary economic period.
2.) Flat Yield Curve: A flat yield curve. means that the yield spread between short and long term bonds is relatively close. The cause is due to the variation in changing rates between short- and long-term rates. This yield curve often indicates that investors and traders are concerned about the macroeconomic outlook. Also, this curve indicated that there is no or very little difference in yield if you invest short term or long term. It would be the theory that there is no yield benefits to investing long term verses short term.
3.) Inverted Yield Curve: The inverted yield curve, which is the opposite of a normal yield curve, occurs when the interest rates on short-term bonds are higher than the interest rates paid on long-term bonds.
What Does an Inverted Curve Mean?
The inverted curve is feared because historically speaking, it has preceded recessions. in the United States. Here are just a few examples: In 1998, the curve inverted after the collapse of the Soviet Union which resulted in a massive Russian debt default; in 2006, when the curve inverted, it was followed by the Great Recession; and, most recently, in 2019, the curve inverted following a series of interest rate hikes by the Federal Reserve. Now 2020 has been hit by a global pandemic which in turn triggered an unprecedented economic downturn, record unemployment, and could even be contributing to the civil unrest brought about by recent police brutality issues. If the history of the inverted curve proves to be true, then it can be assumed that the global pandemic was simply the catalyst needed to bring about an economic downturn.
Although there is no definitive connection between the two and there are many unique circumstances surrounding recent events, the indicator remains strong. The inverted curve means that more investors are investing in long-term bonds, showing signs of uncertainty and nervousness toward the slowing market. They are looking to get out of short-term investments to protect their wealth. Consumers should be wary about the future of their economic status, while at the same time understanding that the curve is not a crystal ball that provides a clear view of the market’s future.
Interested in more information? See our article on Understanding the CLO and CMBS Market.