Interest rates are perhaps the most important indicator of how an economy is performing. Short-term interest rates can show investors how central banks are acting to increase or decrease economic growth, while long-term interest rates show where the market expects inflation to land over the coming years. These insights can be invaluable in helping international investors find opportunities in markets around the world.
What Is a Yield Curve?
Most investors assume that short- and long-term interest rates move in the same direction but that’s not always the case.
Short-term interest rates are set by central banks. For example, the Federal Reserve’s Open Market Committee, or FOMC, sets the federal funds rate that serves as a benchmark for short-term interest rates. Commercial banks can essentially borrow unlimited amounts of money at these interest rates and that creates a floor for the market. The goal of manipulating short-term interest rates is to stimulate or cool down economic growth.
Long-term interest rates are determined by market forces. These interest rates are based on the market’s expectations of future inflation. For example, short-term rates that are set too low could lead to higher future inflation expectations and rising long-term interest rates. There are therefore scenarios where short-term interest rates may be falling and long-term interest rates will be rising if the market thinks that short-term rates are set too low.
A yield curve is created by plotting interest rates—or bond yields—across various maturities. For example, a yield curve may consist of a one-month, three-month, six-month, nine-month, one-year, three-year, five-year, 10-year, 20-year, and 30-year bond yields at a given point in time. The slope and shape of the yield curve tell investors something about the state of the market at a given point in time—including information that could be of predictive value.
Predicting Market Cycles
A reasonable level of inflation is a healthy indicator for the economy and long-term interest rates show where the market expects inflation to be over the long-term.
A yield curve that suggests interest rates will increase over the next couple of years means that you may want to consider increasing allocations toward cyclical companies, such as luxury goods, given the expected uptick in the economy. On the other hand, a yield curve that suggests that interest rates will decline over the next couple of years means that you may want to consider more defensive investments, such as consumer staples.
Inverted yield curves—or flattening yield curves—are among the most common signals for an upcoming recession or downturn in the economy. For example, in December of 2017, strong economic growth and the lack of inflation caused the yield curve to flatten, which led to many analysts calling for an economic downturn moving into 2018.
Yield curves have become a little more difficult to use for prediction purposes since the global economic recession. With interest rates at record lows, short-term interest rates cannot be lowered much more, which means that the yield curve is dictated only by long-term yields driven by market expectations. These market expectations tend to change even more dramatically depending on the economy, which makes long-term predictions difficult.
Tips for International Investors
Global yield curves are a great way for top-down international investors to predict an economy’s performance and find investment opportunities.
In the case of emerging markets and frontier markets, it’s important to remember that bond yields may depend on external factors. A great example would be an economy that’s dependent on energy exports for growth, which limits the ability of yield curves to accurately predict where an economy is headed beyond energy market expectations. Other economies may be dependent on benefactors or even foreign currencies like the U.S. dollar.
It’s also important to remember that yield curves should be only one part of a diversified due diligence strategy. Oftentimes, yield curves are used during a top-down analysis of investment opportunities. Investors may narrow down what sectors may benefit the most from interest rate trends before diving into the fundamentals of these sectors and then looking into individual foreign stocks, American Depositary Receipts (ADRs), or exchange-traded funds (ETFs).
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.