| Understanding the Yield Curve |
by S. Wade Hansen Looking into the Interest Rate Crystal Ball The yield curve is a favorite market indicator of analysts and investors around the world, but what can it tell us? How can we use the yield curve to analyze current market conditions and project future market conditions? The yield curve can tell us a lot about what investors' expectations for interest rates are and whether they believe the economy is going to be expanding or contracting.  The yield curve is a graph that plots the relationship between yields to maturity and time to maturity for a group of bonds. Along the x-axis of a yield-to-maturity graph, we see the time to maturity for the associated bonds, and along the y-axis of the yield-to-maturity graph, we see the yield to maturity for the associated bonds. When you hear people talking about the yield curve, they are most likely talking about the yield curve for U.S. Treasuries. However, virtually any group of bonds or other fixed-rate securities that come from the same asset class and share the same credit quality can be plotted on a yield curve. For this discussion, we will be referring to the yield curve for U.S. Treasuries. Slope of the Yield Curve The slope of the yield curve provides analysts and investors with the important information they are looking for. Typically, you will see one of the following three slopes on your yield curve: - Normal yield curve - Flat yield curve - Inverted yield curve Normal Yield Curve: A normal yield curve tells us that investors believe the Federal Reserve is going to be raising interest rates in the future. Typically, the Federal Reserve only has to raise interest rates when the economy is expanding and the Fed is worried about inflation. Therefore, a normal yield curve often precedes an economic upturn.  Image of a Normal Yield Curve in relation to the S&P 500 on 17 March 2003---Chart courtesy of StockCharts.com Flat Yield Curve: A flat yield tells us that investors believe the Federal Reserve is going to be cutting interest rates. Typically, the Federal Reserve only has to cut interest rates when the economy is contracting and the Fed is trying to stimulate growth. Therefore, a flat yield curve is often a sign of an economic slowdown.  Image of a Flat Yield Curve in relation to the S&P 500 on 9 March 2006---Chart courtesy of StockCharts.com Inverted Yield Curve: An inverted yield curve tells us that investors believe the Federal Reserve is going to be dramatically cutting interest rates. Typically, the Federal Reserve has to dramatically cut interest rates during a recession. Therefore, an inverted yield curve is often a sign that the economy is in, or is headed for, a recession.  Image of an Inverted Yield Curve in relation to the S&P 500 on 31 January 2007---Chart courtesy of StockCharts.com NEXT: Learn more about The Federal Reserve's Response to the Credit Crisis. Keep up with us:
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3.25 Copyright (C) 2007 Alain Georgette / Copyright (C) 2006 Frantisek Hliva. All rights reserved." |
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