Treasury Yield Curve
Beware the Flattening Yield Curve
The U.S. Treasury yield curve compares the yields of short-term Treasury bills with long-term Treasury notes and bonds. The U.S. Treasury Department issues Treasury bills for terms less than a year. It issues notes for terms of two, three, five, and ten years. It issues bonds in terms of 20 and 30 years. All Treasury securities are often called "notes" or "Treasurys" for short.
The Treasury Department sets a fixed face value and interest rate for Treasurys.
It then sells them at an auction. High demand will drive the price above the face value. That decreases the yield because the government will only pay back the face value plus the stated interest rate.
Low demand drives the price below the face value. That increases the yield because the buyer paid less for the bond, but receives the same interest rate. That's why yields always move in the opposite direction of Treasury bond prices. Treasury yields continuously change because they are resold daily on the open market.
The yield curve describes the yields for Treasury bills, notes, and bonds. It's called a curve because, if it were plotted on a graph, the yields would normally slope up. That's because Treasury bills, which are of short duration, don't usually pay as high a yield as medium-term notes and long-term bonds. Why? Investors don't expect a high rate of return for keeping their money tied up for a short period.
They do, however, expect a higher return for keeping their money out of circulation for decades.
It's hard to imagine that someone would buy a 30-year Treasury bond and just let it sit, knowing the return on their investment was only a few percentage points. But some investors are so concerned about losses that they are willing to forgo a higher return on their investment in the stock market or real estate.
They know that the federal government won't default on the loan.
In a world of uncertainty, many investors are willing to sacrifice a higher return for that guarantee. That's important, even though investors don't buy Treasurys and hold them. They resell them on the secondary market. That's where holders of Treasurys sell them to institutional investors such as pension funds, insurance companies, and retirement mutual funds.
Types of Yield Curves
There are three types of yield curves. They tell you how investors feel about the economy. For that reason, they are a useful indicator of economic growth.
A normal yield curve is when investors are confident. They shy away from long-term notes, causing those yields to rise steeply. That means they expect the economy will grow quickly.
What does this mean to you? Mortgage interest rates and other loans follow the yield curve. When there's a normal yield curve, a 30-year fixed mortgage will require you to pay much higher interest rates than a 15-year mortgage. If you can swing the payments, you'd be much better off, in the long run, trying to qualify for the 15-year mortgage.
A flat yield curve is when the yields are low across the board. It shows that investors expect slow growth.
It could also mean that economic indicators are sending mixed messages, and some investors expect growth while others aren't as sure.
When the yield curve is flat, you aren't going to save as much with a 15-year mortgage. You might as well take the 30-year loan, and invest the savings for your retirement. Better yet, apply the savings against the principle and look toward the day you can own your home free and clear.
A flat yield curve means that banks probably aren't lending as much as they should. Why? They don't receive a lot more return for the risks of lending out money for five, ten or 15 years. As a result, they only lend to low-risk customers. They are more likely to save their excess funds in low-risk money market instruments and Treasury notes.
Here's an example of the conditions that create a flat yield curve.
The yield curve reached a post-recession peak on January 31, 2011. The 2-year note yield was 0.58. That's 2.84 basis points lower than the 10-year note yield of 3.42. That difference is called the Treasury yield spread. The most commonly quoted spread is between the 2-year note and the 10-year note. That spread revealed an upward-sloping yield curve.
The yield curve has flattened since then. In 2012, the economy was growing at a healthy rate of 2 percent. But the eurozone debt crisis created a lot of uncertainty. When the monthly jobs report came in lower than expected, panicked investors sold stocks and bought Treasurys. On June 1, 2012, the 10-year Treasury note hit a 200-year low in intra-day trading. The yield on the 2-year note was 0.25, while the yield on the 10-year was 1.47. Investors had become less optimistic about long-term growth. They didn't require as much of a yield to tie up their money for longer. The spread fell to 1.22.
On July 1, 2016, the 10-year Treasury yield hit a new record low of 1.385 during intraday trading. Investors worried about Brexit, Great Britain's vote to leave the European Union. By then, the yield curve had become even flatter. The spread was just 0.87. That's because investors were not very confident of future growth. It's also because the Fed raised the fed funds rate in December 2015. That forced the yield up on short-term Treasury bills.
Since then, the yield curve has continued to flatten.Even though the 10-year Treasury yield has risen above 3 percent, the short-term yields have risen faster. As a result, the difference between them has shrunk.The spread was only 0.52.
Significant Events in the Yield Curve
|Treasury Security||Yield at Close|
|10-year note||3.42||1.47 (200-year intra-day low)||1.46 (new intra-day low of 1.385)||3.00 (1st time since 2014)|
Some analysts are forecasting an inverted yield curve for early 2019. It occurs when short-term yields are higher than long-term yields. It's an unusual situation where investors demand more yield for the short-term bills than they do for the longer-term notes and bonds. Why would this happen? They expect the economy to do worse in the next year or so and then straighten out in the long run.
That's why an inverted yield curve usually forecasts a recession. In fact, the yield curve inverted before both the 2000 and the 2008 recession.