The terms “flat yield curve” and “steep yield curve" crop up frequently in financial media, but what do they mean? Why are they important, and what do these changes in the yield curve indicate? Understanding these changes and their implications can be critical to a solid investment approach.
The Yield Curve: A Review
A yield curve is simply the yield of each bond along a maturity spectrum that's plotted on a graph. It provides a clear, visual image of long-term versus short-term bonds at various points in time.
The yield curve typically slopes upward because investors want to be compensated with higher yields for assuming the added risk of investing in longer-term bonds. Keep in mind that rising bond yields reflect falling prices and vice versa.
A flat yield curve indicates that little difference, if any, exists between short-term and long-term rates for bonds and notes of similar quality.
The general direction of the yield curve in a given interest-rate environment is typically measured by comparing the yields on two- and 10-year issues, but the difference between the federal funds rate and the 10-year note is often used as a measurement as well.
What Is a Flat Yield Curve?
In the image above, you'll notice that the curve starts to flatten (level off) toward the end. The underlying concept of a flattening yield curve is straightforward. The yield curve flattens—that is, it becomes less curvy—when the difference between yields on short-term bonds and yields on long-term bonds decreases.
Here's an example. Let's say that on Jan. 2, a two-year note is at 2%, and a 10-year note is at 3%. On Feb. 1, the two-year note yields 2.1% while the 10-year yields 3.05%. The difference went from 1 percentage point to 0.95 percentage points, leading to a yield curve that has flattened. While the curve may not be flat per se, it has less curve than before.
Why Does a Yield Curve Flatten?
A flattening yield curve can indicate that expectations for future inflation are falling. Investors demand higher long-term rates to make up for the lost value because inflation reduces the future value of an investment. This premium shrinks when inflation is less of a concern.
A flattening yield curve can also occur in anticipation of slower economic growth. Sometimes the curve flattens when short-term rates rise on the expectation that the Federal Reserve will raise interest rates.
This happens because rising interest rates cause bond prices to go down—when fixed-rate bond prices fall, their yields rise.
Higher market interest rates → lower fixed-rate bond prices → higher fixed-rate bond yields
What Is an Inverted Yield Curve?
On the rare occasions when a yield curve flattens to the point that short-term rates are higher than long-term rates, the curve is said to be “inverted.” Historically, an inverted curve often precedes a period of recession. Investors will tolerate low rates now if they believe that rates are going to fall even lower in the future.
Inverted yield curves have occurred on only eight occasions since 1957. The economy slipped into a recession within two years of the inverted yield curve on almost every occasion.
What Is a Steep Yield Curve?
The gap between the yields on short-term bonds and long-term bonds increases when the yield curve steepens. The increase in this gap usually indicates that yields on long-term bonds are rising faster than yields on short-term bonds, but sometimes it can mean that short-term bond yields are falling even as longer-term yields are rising.
For example, assume that a two-year note was at 2% on Jan. 2, and the 10-year was at 3%. On Feb. 1, the two-year note yields 2.1% while the 10-year yields 3.2%. The difference went from 1 percentage point to 1.10 percentage points, leading to a steeper yield curve.
A steepening yield curve typically indicates that investors expect rising inflation and stronger economic growth.
How Can an Investor Take Advantage of the Changing Shape of the Yield Curve?
Think of yield curves as similar to a crystal ball, although not one that necessarily guarantees a certain answer. Yield curves simply offer investors an educated insight into likely short-term interest rates and economic growth. Used properly, they can provide guidance, but they're not oracles.
Yield curves are an investing tool, that should be used with other tools to evaluate an investment.
It pays for most bond investors to maintain a steady, long-term approach based on specific objectives rather than technical matters like a shifting yield curve. But short-term investors can potentially profit from shifts in the yield curve by purchasing some small exchange-traded products, with relatively little trading volume such as the iPath US Treasury Flattener ETN (FLAT), or the iPath US Treasury Steepener ETN (STPP).
These two opposing investment types provide a good method of observing a yield curve while making a small profit if you are inclined to begin speculating in bonds.