What is the yield curve?

Everyone from CNBC anchors to your friends have used the term "yield curve" at some point. In this post, we provide define the yield curve and why it is important for the economy and financial markets.

What is the yield curve?

The yield curve is a graphical representation that displays the relationship between interest rates and the maturity dates of bonds with identical creditworthiness at specific instances in time. The X-axis measures term to maturity (in years) and the Y-axis tracks yield percentages. The yield curve is a tool used by economists, investors, and other interested parties build a view of the financial markets, as the curve can be said to reflect investors' perceptions about future economic conditions.

Interest rates constantly move and depending on where current rates and economic expectations are, they can produce yield curves with different “shapes.” This is why many seasoned corporate treasurers execute strategies like T-Bill ladders to hedge against interest rate volatility risk while generating substantive yield on cash.

Here is a brief overview of the four yield curve types.

1. Normal yield curves

A normal yield curve is an upward growing line that results from a scenario where shorter maturity bonds having lower interest rates than longer maturity bonds. In other words, a 2-year bond will pay you less than a 30-year bond. This yield curve shape is considered "normal" because it is intuitive that there is more risk involved with holding a bond for longer since there are more opportunities for its value to change.

With normal yield curves, the expectation is that the economy will continue to grow and inflation will rise in the future. If these two things do indeed happen, stock prices can increase with economic growth. This is beneficial for those holding equity assets.

For investors, a normal yield curve is a near-ideal economic setup because the Fed will likely not have to change interest rates. However, if the economy does start to overheat, interest rate changes will happen and, as a result, the yield curve shape could change.

2. Steeper yield curves

A steeper yield curve results from longer-term interest rates rising faster than shorter-term rates, signaling to investors that economic growth is on the horizon. Steeper yield curves typically occur before economic expansion or following a recession.

Why? One reason is that the Federal Reserve often reduces interest rates to stimulate economic activity during a recession, which provides low short-term interest rates for borrowers to initiate growth. For example, during the initial stages of COVID, the Fed moved short-term interest rates effectively to zero. After that, the curve began to steepen, and the US economy started recovering rapidly.

Evidence that this type of curve is occurring is that there is a sharper rise at the front part of the yield curve.

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3. Flat yield curves

‍A flat yield curve is usually seen during a transition period of the economy when you see a steeper curve transition to a normal one or from a normal curve to an inverted one (more on this type below). Here is an example of what a flat yield curve should look like:

Since a flat or flattening yield curve signals an economic transition, you could see a rapidly accelerating economy and rising inflation slowly turn into an economic pause. The best way to think about a flat yield curve is economic uncertainty.

4. Inverted yield curves

An inverted yield curve is formed when long-term interest rates are below short-term rates and is one of the more sinister signals a market can see. Investors seeing an inverted yield curve likely believe there could be an economic recession on the horizon and prefer to prioritize longer-term lower rates over growth.

If you see it, expect an economic downturn and possibly a recession. An inverted curve doesn’t necessarily mean a recession is a guarantee. However, economic research has shown it to be a strong historical signal. For example, economist Campbell Harvey once found an inverted yield curve preceded a recession 8 times since 1970.

Before the inversion seen in October 2022, the most recent curve inversion happened in 2019 and several times between 2005 and the 2007 financial crisis. Here is an excellent chart from the St. Louis Federal Reserve. It highlights all curve inversions from the 1970s till now, and recessions are highlighted in gray.

Similar to how you would use a map to find your way to a destination, following the shape of the yield curve can help you make investing decisions.

By that same token, yield curves should never be your only source when assessing the markets, but they should be in the analytical toolbox that helps you make decisions about your cash reserves. Cash preservation is king during volatile times and inverted curves like the one we’ve seen recently.

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