The predictive power of the bond yield curve

If you invest in stocks, you should pay attention to the bond market. If you invest in real estate, you should pay attention to the bond market. If you invest in bonds or bond ETFs, you must pay attention to the bond market.

The bond market is an important predictor of inflation and economic trends, both of which directly affect the prices of everything from stocks and real estate to household appliances and food.

A basic understanding of short-term and long-term interest rates and yield curves can help you make a wide range of financial and investment decisions.

Interest rates and bond yields

The terms interest rate and bond yield are sometimes used interchangeably, but there are still differences.

The interest rate is the percentage that must be paid to borrow money. When you invest in bonds or deposit CDs, you pay interest to borrow money and earn interest to borrow money.

Key points

  • The normal yield curve shows that bond yields steadily increase with the length of maturity, but will flatten out during the longest period.
  • The steep yield curve will not flatten out in the end. This indicates economic growth, and higher inflation may occur.
  • The flat yield curve shows that there is little difference between the yields of short-term bonds and long-term bonds. This shows uncertainty.
  • The rare inverted yield curve indicates trouble ahead. The yield of short-term bonds is higher than that of long-term bonds.

The interest rate of most bonds determines their coupon payment, but the true cost of borrowing or investing in bonds depends on their current yield.

The bond yield is a discount rate that can be used to make the present value of all cash flows of the bond equal to its price. The price of the bond is the sum of the present value of all cash flows received from the investment.

The return of a bond is usually measured by the yield to maturity (YTM). This is the total annualized return that investors will receive if the bond is held to maturity and the coupon payment is reinvested.

Therefore, YTM provides a standard measure of annual returns for specific bonds.

Short-term and long-term

Bonds have a variety of maturities, ranging from one month to 30 years. Generally, the longer the term, the better the interest rate should be. Therefore, when talking about interest rates (or yields), it is important to understand short-term interest rates, long-term interest rates, and many points in between.

Although all interest rates are related, they do not always change simultaneously. Short-term interest rates may fall, while long-term interest rates may rise, and vice versa.

Understanding the current relationship between long-term and short-term interest rates (and all the points in between) will help you make informed investment decisions.

Short-term interest rate

The benchmark for short-term interest rates is set by the central bank of each country. In the United States, the Federal Reserve’s Open Market Committee (FOMC) sets the federal funds rate, which is the benchmark for all other short-term interest rates.

The FOMC will periodically raise or lower the federal funds rate to encourage or prevent companies and consumers from borrowing. Its goal is to keep the economy running smoothly, neither too hot nor too cold.

Lending activities generally have a direct impact on the economy. If the Federal Open Market Committee finds that economic activity is slowing, it may lower the federal funds rate to increase borrowing and stimulate the economy. However, it is also concerned about inflation. If short-term interest rates are kept too low for too long, it may trigger inflation.

The mission of the FOMC is to promote economic growth through low interest rates while controlling inflation. Balancing these goals is not easy.

Long-term interest rate

Long-term interest rates are determined by market forces. These forces mainly play a role in the bond market.

If the bond market perceives that the federal funds rate is too low, expectations for future inflation will rise. Long-term interest rates will rise to make up for the loss of purchasing power related to the future cash flow of bonds or loans.

On the other hand, if the market believes that the federal funds rate is too high, the opposite is true. Long-term interest rates have fallen because the market believes that interest rates will fall in the future.

Read the yield curve

The term “yield curve” refers to the yield of U.S. Treasury bonds, bills and bonds, from the shortest to the longest maturity. The yield curve describes the shape of the term structure of interest rates and their respective maturities (in years).

The curve can be displayed graphically, the expiry time is on the x-axis of the chart, and the yield to maturity is on the y-axis of the chart.

For example, treasure.gov shows the yield curve of the following U.S. Treasury bonds on December 11, 2015:

U.S. Treasury yield curve

The above yield curve shows that bonds with shorter maturities have lower yields and have steadily increased as bonds mature.

The shorter the maturity, the more we can expect the rate of return to move in tandem with the federal funds rate. Observing further points on the yield curve can better understand the market’s consensus on future economic activity and interest rates.

The following is an example of a yield curve for January 2008.

U.S. Treasuries

bill Bar Mitzvah Discount/Earnings Discounts/revenue changes
3 months 04/03/2008 3.12/3.20 0.03/-0.027
6 months 07/03/2008 3.10/3.21 0.06/-0.074
Notes/bonds coupon Bar Mitzvah Current price/yield Price/revenue changes
2 years 3.250 December 31, 2009 101-011/2 / 2.70 0-06+/-0.107
5 years 3.625 12/31/2012 102-04+ /3.15 0-143/4 / 0.100
10 years 4.250 11/15/2017 103-08 / 3.85 0-111/2/ -0.044
30 years 5.000 5/15/2037 110-20 / 4.35 0-051/2 / -0.010

Yield curve for January 2008.

The slope of the yield curve tells us what the bond market expects of future short-term interest rates based on bond traders’ expectations of economic activity and inflation.

This yield curve “inverts in the short term.” This shows that traders expect short-term interest rates to fall in the next two years. They expect the U.S. economy to slow down.

The yield curve is best used to understand the direction of the economy, rather than trying to make accurate predictions.

Types of yield curve

There are several different forms of the yield curve: normal (with “steep” changes), inverted, and flat. All are shown in the figure below.

Normal yield curve

As shown by the orange line in the figure above, the normal yield curve starts with the low yield of lower maturity bonds and then increases for higher maturity bonds. The normal yield curve slopes upward. Once the bond reaches its maximum maturity, the yield will flatten and remain consistent.

This is the most common type of yield curve. Bonds with longer maturities usually have a higher yield to maturity than short-term bonds.

For example, suppose the yield of a two-year bond is 1%, a five-year bond has a yield of 1.8%, a 10-year bond has a yield of 2.5%, a 15-year bond has a yield of 3.0%, and a 20-year bond has a yield of 3.0%. The bond yield is 3.5%. When these points are connected graphically, they assume the shape of a normal yield curve.

Such a yield curve implies stable economic conditions and should run through the entire normal economic cycle.

Steep yield curve

The blue line in the graph shows a steep yield curve. It is shaped like a normal yield curve, with two main differences. First, the higher yield to maturity will not flatten out on the right side, but will continue to rise. Second, the yield is usually higher compared to the normal curve for all maturities.

Such a curve means that the growing economy is moving in a positive direction for improvement. This situation is accompanied by higher inflation, which usually leads to higher interest rates.

Lenders tend to demand high yields, which is reflected in the steep yield curve. Long-term bonds have become risky, so the expected yield is higher.

Flat yield curve

A flat yield curve, also known as a hump yield curve, shows that the yields for all maturities are similar. The yields of some intermediate periods may be slightly higher, which will cause a slight hump along the flat curve. These humps are usually used for mid-term maturity, six months to two years.

As the word flat implies, there is almost no difference between the yield to maturity of short-term and long-term bonds. The two-year bond yields 6%, the five-year bond yields 6.1%, the 10-year bond yields 6%, and the 20-year bond yields 6.05%.

Such a flat or uplifting yield curve means that the economic situation is uncertain. It may happen at the end of a period of high economic growth that has caused fears of inflation and economic slowdown. It may appear when the central bank is expected to raise interest rates.

In periods of high uncertainty, investors require similar rates of return for all maturities.

Inverse yield curve

The shape of the inverted yield curve shown by the yellow line is opposite to the shape of the normal yield curve. It slopes downward.

An inverted yield curve means that short-term interest rates exceed long-term interest rates.

The yield on a two-year bond may be 5%, a five-year bond has a yield of 4.5%, a 10-year bond has a yield of 4%, and a 15-year bond has a yield of 3.5%.

An inversion of the yield curve is rare, but it strongly suggests a severe economic slowdown. Historically, the impact of the inverted yield curve has been a warning of the imminent economic recession.

Historical Yield Curve Accuracy

According to the development of many macroeconomic factors such as interest rates, inflation, industrial output, GDP data and trade balance, the yield curve will change with the development of the economic situation.

Although the yield curve should not be used to predict the exact number of interest rates and yields, closely tracking their changes can help investors predict and benefit from changes in the economy in the short and medium term.

The normal curve exists for a long time, while the inverse yield curve is rare and may not appear for decades. The yield curve changes to a flat and steep shape more frequently, and reliably earlier than the expected economic cycle.

For example, in October 2007, the yield curve flattened, which was followed by a global economic recession. At the end of 2008, the curve became steep, which accurately indicated the growth phase of the economy after the Fed relaxed the money supply.

Use the yield curve to invest

Explaining the slope of the yield curve helps to make top-down investment decisions for various investments.

If you invest in stocks and the yield curve indicates that the economy is expected to slow in the next few years, you might consider transferring funds to companies that performed well during the economic slowdown, such as consumer staples. If the yield curve suggests that interest rates should rise in the next few years, then investment in cyclical companies such as luxury goods manufacturers and entertainment companies makes sense.

Real estate investors can also use the yield curve. Although the slowdown in economic activity may have a negative impact on current real estate prices, the sharp steepening of the yield curve indicates that inflation expectations may be interpreted as meaning that prices will rise in the near future.

Of course, it is also related to fixed income investors in bonds, preferred stocks or CDs. When the yield curve becomes steep-heralding high growth and high inflation-savvy investors tend to short long-term bonds. They don’t want to be locked in returns whose value will be eroded as prices rise. Instead, they buy short-term securities.

If the yield curve flattens out, it will raise concerns about high inflation and recession. Smart investors tend to short short-term securities and exchange-traded funds (ETF) and long long-term securities.

You can even use the slope of the yield curve to help decide whether to buy a new car. If economic activity slows down, new car sales may slow down, and manufacturers may increase rebates and other sales incentives.

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