Importance of the Yield Curve for Investors

Fajasy
Updated: September 5, 2019

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In this article, I will discuss the importance of the yield curve for investors, what it really means when it flattens and inverts, and what steps investors can take when the yield curve changes shape.

In short, the yield curve is a curve that many analysts reference when discussing the economy. In reality, the yield curve is rather straightforward, as it visualizes the difference in interest rates between different bond maturities.

Its shape also helps to forecast interest rates and economic activity. When this yield curve inverts, it also acts a strong leading indicator of an upcoming recession.

An Introduction to the Yield Curve

Before getting into the yield curve, it's important that you know what the "yield" in "yield curve" refers to. In the stock market, what is often being referred to is the dividend yield, a financial ratio that shows how much a company pays out in dividends every year relative to its stock price.

However, with the yield curve, what is being referenced is the bond yield. This is the interest or coupon payment of a bond as a percentage of its price. The yield therefore tells you how much money your investment is generating.

For example, if a bond pays a coupon of $50 per year and it's trading at $1000 (aka; face or par value), its yield would therefore be 5% ($50 / $1000). If the value of the bond happened to drop to $950 instead, its yield would go up to 5.3% ($50 / 950).

If you purchased this bond at $1000 and held until maturity (until the bond expires), then this drop in bond value doesn't mean much. However, if you sell your bond, this will make it more attractive to investors as they'll be receiving the same yield, just for $50 less. On the other hand, if the price of your bond increases in price, then it will become less attractive to investors.

The yield curve is based on the U.S. Treasury bonds, which are bonds issued by the U.S. government. So, if you take these Treasury bonds from a variety of maturities and plot their yields, you will typically end up with a curve like the one shown below.

As you can see, the yield curve is a curve that is plotted on a chart with the yield percentage on the y-axis and the bond maturities on the x-axis.

So, when the yield curve is positive, the yields of shorter maturities will always have lower yields than those of longer maturities.

You can also use any combination of maturity dates to form a yield curve. This was done in the chart above where I combined 2-year, 5-year, 10-year, 20-year, and 30-year bond maturities to create a single yield curve, using the current treasury yield curve rates.

In short, this display of yields across different maturities will help you make sense of the risks and potential rewards of different Treasury bonds. The yield curve, regardless of its shape, can also be used to reference other fixed-income investments. This includes different types of bonds and certificates of deposits (CDs). This is because the actual shape of the yield curve can provide insight into the future of interest rates, as later discussed.

With all things considered, the yield curve is rather straightforward. It simply visualizes the difference in interest rates between different bond maturities. Often time, analysts and investors alike don't even use the entire curve, and just use a single number called the yield spread. This is the difference between the 10-year and the 2-year Treasury bond yields.

Implications of a Positive Yield Curve

To begin, when the yield curve is positive, or normal, investors may expect economic growth which can lead to inflation and ultimately higher interest rates. Higher interest rates are negative for longer maturities, so they demand a higher yield to compensate for this risk.

For example, since the financial crisis in 2008, investors have been expecting economic growth and higher interest rates. These expectations have therefore resulted in a positive sloping yield curve.

So, when the yield curve is positive, longer-term Treasury bonds pay investors higher interest rates. This is because long-term bonds pose a higher risk to investors than short-term bonds, simply because your money will be held for a longer period of time.

Ultimately, this creates more risk, and any negative or major economic activity may impact the value of your bond. This can also bring about a more attractive bond investment.

For example, let's say we have Investor A that purchases a 2-year government bond, and Investor B that purchases a 10-year government bond. These bonds were purchased at the same time. One year passes and the government begins to issue higher interest rate bonds. Unfortunately, this hurts the value of both 2-year and 10-year bonds both investors purchased, as they are now less attractive.

However, Investor A with the 2-year bond would not be concerned, as he/she will get the full amount borrowed by the government (aka; face or par value) in one year when it matures. Investor A could then move into the more attractive higher interest rate bond.

On the other hand, Investor B, or the 10-year bond investor will have to wait much longer, even though there's a much more attractive bond investment option available. Therefore, Investor B has to either sell the bond at a discounted price, or wait 9 more years and accept the lower return the entire time.

In short, longer-term bonds offer less flexibility to investors. As a result, they tend to pay investors a premium coupon rate (a higher interest rate) to compensate them for the added risk. This is also what causes the upward sloping yield curve, which is otherwise known as the normal yield curve.

When the Yield Curve Flattens

As you may know, the yield curve doesn't always look normal. Sometimes, the yield curve can flatten, which happens when yields for short and long-term bond maturities are roughly equal.

When this occurs, it's usually a transition from positive to inverted, or from inverted to positive. The chart below highlights seven times in recent history when the yield curve was flat, with the maturities and yield percentages displayed on the X and Y axis respectively.

As you can see, this shape forms when yields of short and long-term maturities are roughly equal.

This occurs when short-term yields increase more than long-term rates, or when the long-term yields fall more than short-term interest rates. This plays a part in the yield equation, with the bond's coupon payments and the bond's price.

Short-term maturities can be influenced heavily by the Fed changing interest rates, whereas long-term maturities cannot. This is because it will take a long time for all outstanding long-term bonds to mature, and for this new interest rate to reflect on the yield curve. However, if people start demanding more long-term bonds, it will cause prices to rise.

In other words, if more people purchase longer-term bonds, it will weigh down long-term bond yields and cause the yield curve to flatten.

This is not a good thing at all, because the previously high yield for long-term bonds will be no more attractive than that of short-term bonds.

This typically happens when investors believe that there is some greater risk out there that outweighs the risk of longer-term bonds. For example, if investors expected future interest rates to fall, or for their stock market investments to perform poorly, they would purchase long-term bonds. Therefore, these investors are accepting these lower returns just to ensure they have some long-term source of interest.

So, when there's less consumer demand in the market, rising debt levels, or high levels of unemployment, among many other factors that can cause a slowing economy, it may be the case that the yield curve is flattening.

Regardless of the reason, investors will begin purchasing long-term government bonds, and if the situation doesn't improve, the yield curve could then invert.

The Inverted Yield Curve and Why it Happens

The inverted yield curve occurs when yields of shorter maturity bonds are higher than longer maturity bonds. In particular, the Fed's preferred measure to gauge an inverted yield curve is the difference between the 10-year and 3-month treasury yields.

Below is the inverted yield curve and how it compares to the normal and flat yield curves:

As mentioned before, this curve forms when investors expect economic growth to slow. If economic growth slows, investors may also expect interest rates to fall. These expectations therefore increase the demand for higher-yielding maturities which drives the yields of longer-term maturities lower.

So, when the yield curve inverts, long-term lenders are taking a lower interest rate than the short-term lenders.

One reason for an inverted yield curve can be with the Federal reserve tightening monetary policy, which has been historically loose for the last decade. So, if the Fed begins to increase interest rates and people are on the margin of being able to borrow at the old rate and can't borrow at the higher rate, lending begins to slow down.

This, coupled with other economic conditions such as trade-wars, slowing down of the European market, and the slowing gross domestic product, can all cause the economy to slow down and for the yield curve to invert.

Moreover, the yield curve is not just determined by what investors want, it's also about what lenders are willing to offer. So, if interest rates were expected to fall in the next 2-5 years, investors would want to purchase long-term maturities now to lock in the higher interest payment rates for as long as possible.

However, when this mass buying happens, the price of this long-term bond goes up, and the higher this demand becomes, the lower the yield is. This is because investors pay a higher price for the bond so their total return from the bond will be lower.

This is caused by lenders who are not willing to offer higher rates on longer maturities, because practically everyone expects interest rates to fall. If investors could, they would purchase the longest-term highest interest rate security they could find if they thought interest rates were going to fall. However, this is not possible because lenders simply don't want to offer these higher interest longer-term maturities to investors.

Predictive Power of the Yield Curve

Historically, inverted yield curves have been leading indicators of recessions. In fact, the inverted yield curve has correctly predicted a recession each of the 6 times in the last 5 decades!

If the yield curve inverts, it does not mean a recession will always happen. Sometimes, the inversion may return back to normal if the economy is no longer in a slowdown. Other times, the inverted yield curve may only last a few weeks before it's a true inversion and can actually indicate an upcoming recession. So, although the inverted yield curve is a strong indicator of an upcoming recession, it should never be taken for granted.

In addition, there also appears to be no correlation between the difference of the yield curve and the longevity of the past recessions.

Now, if the yield curve happens to invert again, it could still take some time before it actually hits. The usual time delay between the yield curve inverting and the onset of a recession is within about 7 to 24 months. Therefore, if the yield curve inverts, it could be well into next year until we see a major economic impact and a slowdown of the U.S. economy.

Examples of Inverted Yield Curves and Recessions

As mentioned before, history has seemed to backup the predictive power of the yield curve.

To begin, if you look at the yield curve for the three years leading up to the 2008 financial crisis, you can see a pretty clear trend in the shape of the curve. The same goes for the 2000 tech bubble, as outlined below.

Below is another chart which shows the past 6 times the yield curve inverted, and whether a recession followed (the shaded areas). The most recent yield curve inversion in 2019 also led to a recession, primarily due to the coronavirus.

In short, as an investor, it's wise to not ignore the inverted yield curve and to also keep track of when the yield curve changes shape.

What You Should Do When the Yield Curve Inverts

To begin, the yield curve is far from exact science. As mentioned before, there is typically a 7 to 24 month delay before a recession even hits after the yield curve inverts. Other times, the yield curve only lasts a few weeks before returning to normal.

Therefore, while you can hedge risk, attempting to pinpoint the next recession and timing the markets is not a smart thing to do. Moreover, although you should be aware of the yield curve's shape, watching this yield curve everyday will likely not put you any further ahead of other investors.

The best approach is to therefore just make sure your bases are covered. History has shown that it's very possible that a recession is on the horizon with an inverted yield curve. Regardless, you should never sell all of your stock market investments because of a prolonged inverted yield curve.

Investing is a long-term process, and it takes a lot of patience to really see the benefits. Many people panic when they see an inverted yield curve because they don't truly know their investments. These people then get freaked out and sell when an inverted yield curve comes or when the market crashes.

If you're not a complete passive investor, you should keep a watch-list of companies that you're interested in investing in. Really vet these companies and understand their business model and the value they provide to their customers long-term.

Then, once the stock market prices of these companies drop in the recession, you'll be able to purchase these great businesses at discount prices. A temporary crash of the market that lasts a year or so will not put great companies under. Instead, it will make these companies available for sale which you can then potentially own for the long-term.

So, when you position yourself to be able to pull the trigger during the market correction, you're going to be in a much better position by the time the market starts to recover.

The Bottom Line

In short, here are the four main things you should follow to minimize the impact of a recession:

  • Do you own due diligence on all of your investments.
  • Diversify your investments, both inside and outside the stock market.
  • Have a strong emergency fund.
  • Ensure your investment risk exposure matches your tolerance levels.

Furthermore, if you are largely a fixed income investor and want to manage changes in the yield curve, one good strategy is to diversify your fixed income portfolio across different maturities, and even among different issuers and credit qualities. This is similar to "bond laddering," which allows investors to respond more quickly to changes in interest rates.

Besides all of this, there's not much else you need to do as a long-term investor. After all, if you hold a portfolio of high-quality companies, you don't need to worry about the short-term implications of a recession.

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