Yield Curve : Investment and Economic Indicator

In his book The Strategic Bond Investor, author and bond-market strategist, Tony Crescenzi, notes that a yield curve is “the closest thing the bond market has to a crystal ball”. That being the case, it is a good idea to understand what a yield curve is and how it can assist in investment decisions. A yield curve is a line representing the interest rates (cost of borrowing), at any given time, of bonds with equal credit quality, but different maturity rates. A yield curve is also referred to more formally as the term structure of interest rates.

An example of a yield curve can be seen in U.S. dollar interest rates which are paid on U.S. Treasury securities measured against various maturity dates. The most commonly measured and reported yield curve makes a comparison of three-month, two-year, five-year and 30-year U.S. Treasury debt. The resultant yield curve is then used as a benchmark for measuring other debt in the market, including bank lending rates and mortgage rates.

The shape of the yield curve is of great interest to investors and analysts because it is a relatively reliable indicator of future interest rate change, as well as economic activity. There are three primary yield curve shapes, being normal, inverted and flat, sometimes referred to as humped. A normal yield curve has an upward sloping shape (like a rainbow), and this would indicate longer maturity bonds having a higher yield in comparison to shorter-term bonds, due to the risks that are associated with time. An inverted curve, on the other hand, indicates shorter-term yields being higher that longer-term yields and this may be interpreted as a sign of upcoming recession. A flat, or humped yield curve, reveals that shorter-term and longer-term yields are very close, and is seen as an indicator of an economic transition. Also, the slope of the yield curve is significant, as the greater the slope, the greater the difference between short-term and long-term rates. Fixed income analysts use yield curves to analyze bonds and related securities in order to better understand conditions in financial market and to assist in identifying trading opportunities. Yield curves are used by economists to gauge economic conditions.

Currently, in the U.S. economy, Treasury two-year notes, which have been the worst performing U.S. government securities over the past year, may very well beat longer-term debt. This is primarily due to the interest rate cuts implement by the Federal Reserve in an effort to pull the U.S. economy out of a downward spiral. The yield curve measuring two-year and 10-year notes is currently at 2.44 percentage points and is expected to widen to 3 percentage points. No doubt investors will be watching all investment indicators, including yield curves, as the U.S. enters the transition period of replacing the Bush administration with the Obama administration.