What Is The Yield Curve Saying?

With all the talk and rage about the yield curve and what it may signal, its important to take a step back to analyze what a yield curve is, what it’s meant to share with investors, and how it can lead the future direction of the economy. 

 Basic Fixed Income Formula (vice versa): 

 Interest Rates     +     Prices     -       Yields     +

First, the U.S. Treasury yield curve showcases the yields of short-term Treasury bills compared to the yields of long-term Treasury notes (maturities from 2-10 years) and bonds (maturities greater than 10 years). It displays the relationship between the interest rates and the maturities of U.S. Treasuries that range from 1, 2, 3, and 6 months and 1, 2, 3, 5, 7, 10, 20, and 30 years.

Second, the yield curve can behave in three different ways: flat, inverted or steep. 

A flat yield curve is when yields are similar across all maturities. A few intermediate maturities may have slightly higher yields, which causes a slight hump in the early to middle part of the curve, and are usually for the mid-term maturities, six months to two years. Such a flat or humped yield curve implies an uncertain economic situation. It may come at the end of a high economic growth period that is leading to inflation and fears of a slowdown. It might appear at times when the central bank is expected to increase interest rates.

An inverted yield curve is when yields slope downward and means that short-term interest rates exceed long-term rates. Such a yield curve corresponds to periods of economic recession where investors expect yields on longer-maturity bonds to become even lower in the future. Moreover, in an economic downturn investors seeking safe investments tend to purchase these longer-dated bonds over short-dated bonds bidding up the price of longer bonds hence, driving down their yield.

A normal or steep yield curve is when yields on longer-term bonds may continue to rise responding to periods of economic expansion. This type of yield curve states longer-maturity bonds have a higher yield to maturity than shorter-term bonds.

Third, based on how short and long rates move, there are two main ways to classify it’s moves: 

A flattener is when traders and/or investors would want to “sell the spread” meaning they would short the front end of the yield curve and long the back end. This occurs from one of two scenarios:

A bull flattener is when longer term rates and decreasing faster than shorter term rates. This typically happens when the change in the yield curve often precedes the Fed lowering short term interest rates, which is bullish for both the economy and the stock market. 

A bear flattener is when short term rates are rising faster than long term rates. This typically happens when the change in the yield curve often precedes the Fed raising short term interest rates, which is bearish for both the economy and the stock market.

A steepner is when traders and/or investors would want to “buy the spread” which would mean they buy the front end of the yield curve and short the back end. This again occurs from one of two scenarios:

A bull steepener is when short term rates are falling faster than long term rates. This often happens when the Fed is expected to lower interest rates which is a bullish sign for both the economy and stocks.

A bear steepener is when long term rates are rising faster than short term rates. This often happens when inflation expectations pick up at which point the market may anticipate a fed rate increase to battle upcoming inflation which would be bearish for both the economy and stock market.

Given the current environment, we find ourselves with an inverted yield curve on several maturities across the yield spectrum. The five-year yield inverted against the thirty-year yield last week and again today. Late last week, the two-year yield was inverted above its longer-term counterparts. This clearly shows an inverted yield curve and bear flattener scenario as short rates are rising faster than long rates which historically indicates investors are bracing for rotation into safer assets and those that can withstand an economic downturn.  

Investors and traders alike can also use ETFs to track Treasury yields among different maturities:

$FVX – 5 Year Treasury Yields;

$TNX – 10 Year Treasury Yields;

$TYX – 30 Year Treasury Yields;

Other Treasury ETFs:

$TIP – TIPS Bond ETF;

$SHY – 1-2 Year Treasury Bonds;

$IEI – 3-7 Year Treasury Bonds;

$IEF – 7-10 Year Treasury Bonds;

$TLT – 20 Year Treasury Bonds;