Treasury Yield Curve

How to Use Normal, Flat, and Inverted Yield Curves to Predict the Future

Treasury yield curve
Yield curves predict the cost of fixed-rate loans. Photo: Steve Debenport/Getty Images

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 drives 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 the notes and even longer-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 10 - 20 years.

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 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 fell about the economy. For that reason, they are a useful indicator of economic growth.

A normal yield curve is when investors are confident, and 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 fifteen 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.

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. One month later, on July 24, it went even lower.

On July 1, 2016, the 10-year Treasury yield hit a record low of 1.385 during intraday trading. Investors worried about Great Britain's vote to leave the European Union. By then, the yield curve had become even flatter than it was in 2012. 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 returned to normal. The economy is improving, and investors are selling Treasurys and buying stocks instead.

Treasury Security                  Yield at Close
 6/1/12 7/25/12 7/1/20166/14/2017
1-month bill 0.03 0.08 0.240.90
3-month bill 0.07 0.10 0.281.01
6-month bill 0.12 0.14 0.371.12
1-year note 0.17 0.17 0.451.20
2-year note 0.25 0.22 0.591.35
3-year note 0.34 0.28 0.711.48
5-year note 0.62 0.56 1.001.74
7-year note 0.93 0.91 1.271.96
10-year note 1.47 (200-year low) 1.43 (new record low) 1.46 (new intra-day low of 1.385)2.15
20-year note 2.13 2.11 1.812.53
30-year bond 2.53 2.47 2.242.79

 

Here's an example of how the yield curve is used to predict economic growth. In July 2010, the flat yield curve prompted the Cleveland Federal Reserve to predict the U.S. economy would only grow 1 percent that year. In fact, the economy grew 2.5 percent, thanks to low-interest rates that boosted demand. The yield curve had flattened due to fear stemming from the Greece debt crisis

An inverted yield curve is 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.