What Lies Beneath Yield Curves

If you follow the financial news, you must have frequently heard the term Yield Curves and analysts stating its importance in predicting the state of the economy. It is most often discussed as a predictor for an upcoming recession or market downfall. While increasing debt levels, economic and global government policies play a major role in determining a recession, the yield curve provides investors with a useful insight about the present scenario.

Simply put, the yield tells you how much money your money is making. While dividend yields are an annual percentage on your stock investment, the yield curve represents the annual yield on bonds.

Bond Yield = Annual Coupon Payment ÷ Bond Price

Thus if a bond is trading at $100 with an annual coupon payment of $5, the bond yield is 5%.

bond-yield_v_price

Bonds are debt instruments, and while there are various types of bonds, the ones that are represented on the yield curve are U.S. Treasury Bonds. Here’s a basic plot of yield v/s maturity showing 3 types of yield curves: Normal, Flat and Inverted.

Yield-Curve-1024x682

You may have seen various maturity term bonds ranging from 1 month to 30 years. If you wish to view the current yield on different maturity bonds, click here

Let us examine each of the three curves to never have that confused look when someone mentions the two frightening words : YIELD CURVE

1.  NORMAL CURVE

As the name suggests, this is the best case scenario for all investors. The normal yield curve is upward sloping, meaning, the yield on higher maturity bonds is higher than short term maturity bonds.

Too much jargon? Let’s simplify with a simple example

Let us say that a 2 year bond offers a 2% yield while a 30 year bond offers a 2.5% yield. Which one are you more likely to buy?

While the 30 year bond offers a higher yield, it also comes with an uncertainty over a very long period of time. As an investor this long term bond presents higher risk due to the long term uncertainty associated with it. This is the reason why a higher yield is being offered on higher maturity bonds.

Therefore, if long term yields are higher than short term maturity yields, the yield curve is normal, suggesting a balanced economy. Investor sentiment indicates a positive outlook showing signs of a stable and growing economy.

2.  FLAT CURVE

There can be two reasons for a flat yield curve:

  • Short term maturity rates are increasing
  • Long term maturity rates are decreasing

What does this imply? Each scenario represents a change of faith in the economy. When investors demonstrate uncertainty in current times, they tend to invest in long term bonds, thereby driving the prices up. This will lower the yield rates for long term bonds and flatten the yield curve.

There can be multiple reasons why investors believe there is some greater risk that outweighs the risk of long term bonds such as:

  • Slowing economy
  • Expectation of interest rates to fall
  • Expectation that other investments will under perform

Flattening of the curve is always the predecessor to curve inversion, and demonstrates a relatively negative outlook for the economy.

3.  INVERTED CURVE

The inverted curve simply suggests that investors are ready to accept low return on long term bonds as opposed to high return on short term bonds. This happens when there is extreme uncertainty in the market, and a lack of faith in the economy, forcing investors to purchase low return investments to simply secure their financial future. During this time short term bonds have fewer buyers thereby lowering the price and driving the yield higher.

What sign am I really looking for?

Now that we understand what each yield curve indicates, let us look at the important indicator of an upcoming recession. Historically, an inverted yield curve is noted before major recessions of 1991, 2000 and 2008.

Capture
Source: SeekingAlpha

A flattening curve indicates a slowing economy which hurts the profitability of financial institutions and makes access to capital difficult for corporations. This results in slow growth for businesses, reducing sales and revenue numbers, thereby causing low demand and lower stock prices. When this is followed by an inverted yield curve, market participants are no longer looking to grow their investment, but are running to safeguard their finances.

Is this enough to predict the future?

Just like many indicators, while the yield curve can provide useful insights, it is not your tell all sign to time the market. However, understanding the market is essential to your financial stability and future. The only person who claims the ability to time the market is a liar!

If you wish to safeguard your investments from a recession, you may want to read my post on 4 ways to harbor your wealth from the next Recession

I hope this post was not too technical and offered you a better understanding of economics and its relation to your investments. If you have any additional thoughts or suggestions, I would love to hear them!

Be Frugal, Be Smart, Be Rich!

Related Links:

Start investing with Mutual Funds – Your guide to Diversification

Is the Market Overvalued or Undervalued?

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