Definition of Steepening and Flattening Yield Curve

The Meaning of Steepening and Flattening Bond Yield Curves

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In the financial media, you’ll hear the terms “flattening yield curve” and “steepening yield curve.” What do these terms mean, and what do changes in the yield curve indicate?

The Yield Curve: A Review

The “yield curve” is simply the yield of each bond along the maturity spectrum plotted on a graph, as shown here. The yield curve typically slopes upward, since investors need to be compensated with higher yields for assuming the added risk of investing in longer-term bonds.

(Keep in mind, Rising bond yields reflect falling prices and vice versa.) The general direction of the yield curve in a given interest-rate environment is typically measured by comparing the yields on the two- and 10-year issues, although the difference between the federal funds rate and the 10-year note are often used as well.

What is a Flattening Yield Curve?

The underlying concept is straightforward. When the difference between yields on short-term bonds and yields on long-term bonds decreases, the yield curve flattens, that is, it appears less steep.

Example: On January 2 the two-year note is at 2.00% and the 10-year at 3.00%. On February 1, the two-year note yields 2.10% while the 10-year yields 3.05%. The difference went from one percentage point to 0.95 percentage points, leading to a flatter yield curve.

Why Does a Yield Curve Flatten?

A flattening yield curve can indicate that expectations for future inflation are falling.

Since inflation reduces the future value of an investment, investors demand higher long-term rates to make up for the lost value. When inflation is less of a concern, this premium shrinks. A flattening of the yield curve can also occur in anticipation of slower economic growth. And sometimes, the curve flattens when short-term rates rise on the expectation that the Federal Reserve will raise interest rates.

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 has often preceded a period of recession. Investors will tolerate low rates now if they believe rates are going to fall even lower later on. Inverted yield curves have occurred on only eight occasions since 1958. More than two-thirds of the time, the economy has slipped into a recession within two years of an inverted yield curve.

What Is a Steepening Yield Curve?

When the yield curve steepens, the gap between the yields on short-term bonds and long-term bonds increases, making the curve appear "steeper." The increase in this gap indicates that yields on long-term bonds are rising faster than yields on short-term bonds or, occasionally, that short-term bond yields are falling even as longer-term yields are rising.

Example: On January 2 the two-year note is at 2.00% and the 10-year at 3.00%.

On February 1, the two-year note yields 2.10% while the 10-year yields 3.20%. The difference went from one percentage point to 1.10 percentage points, leading to a steeper yield curve.

Why Does a Yield Curve Steepen?

A steepening yield curve typically indicates investor expectations for 1) rising inflation and 2) stronger economic growth. 

Can an Investor Take Advantage of the Changing Shape of the Yield Curve?

For most bond investors, it pays to maintain a steady, long-term approach based on their specific objectives rather than technical matters such as the shifting yield curve. However, short-term investors can potentially profit from shifts in the yield curve by purchasing either of  two exchange-traded products: the iPath US Treasury Flattener ETN (FLAT) and the iPath US Treasury Steepener ETN (STPP). Both are small and have relatively little trading volume — which is often a disadvantage —  but they nonetheless provide a way to express an opinion regarding the difference between the performances of short- and long-term bonds.

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