Those looking to invest in bonds need ways to determine what the future of the bond market could be, and whether now is the time to make that investment. One predictive tool many investors and economists use to gauge the strength of the upcoming market is the yield curve.
The yield curve is the relationship between interest rates and the maturity date of a bond, showing the difference between what a short-term bond and a long-term bond would yield. With this information, you can get a better sense not only of what bond may be a better value for you at the moment, but where economists are predicting the economy to go.
The direction of the yield curve isn't always necessarily a perfect indicator that the economy is about to hit a high or fall into a recession, but there are still different takeaways that can be found within the curve, like what types of bonds are currently in higher demand.
What Is a Yield Curve Chart?
A yield curve chart plots out the actual yield curve based on several time increments. The maturity of the bond or security is plotted along the x-axis, while the y-axis plots yield in terms of interest rate percentage. Usually, the time increments plotted are yields after maturities of 3 months, 6 months, 1 year, 2 years, 5 years, 10 years and 30 years. These are the maturities used when figuring out the treasury yield curve.
Normal Yield Curve
There are several different types of yield curves that each mean separate things, caused by separate economic factors. In a normal yield curve, short-term securities have a lower yield, while longer-term bonds have a higher yield.
A normal yield curve can at times be an indication of a thriving or on-the-rise economy, but it's called a "normal" yield curve as opposed to a more actively positive term because this curve is what it is generally expected to look like. Long-term bonds are, for the most part, a far riskier investment than short-term. As such, they tend to offer higher yields and interest rates to attempt to counteract the risk of loaning the money for such a long-term endeavor.
If there is a belief that the Federal Reserve will hike interest rates in the future as a result of inflation, the yield curve will curve upward.
Steep Yield Curve
Yield curves can trend upward in different ways. A normal yield curve is what is expected out of a relatively healthy economy. If it curves up in a much steeper way, though, it could be a sign of an economic upturn. If a yield curve is steepening, either long-term yields are rising at a higher rate than short-term, or short-term yields are falling as long-term yields rise.
For example, let's say a 1-year security has a yield of .5% and a 10-year one has a yield of 2%. That's a difference of 1.5 percentage points. If after a couple of months, the 1-year's yield is .6% and the 10-year's yield is 2.5%, that difference is now 1.9 percentage points.
Similarly, if it starts off where the 1-year yields .5% and the 10-year yields 2%, and then after a month the 1-year falls to .3% and the 10-year rises to 2.2%, the percentage difference still went from 1.5 to 1.9. Either way, the yield curve on the graph is going to look steeper.
Flattening Yield Curve
With an upward-trending yield curve, economists may assume inflation will rise or that the economy is healthy. But what happens if those assumptions don't end up being completely correct? What if the economy doesn't continue a steady growth? And what if the inflation assumptions that caused a rise now suddenly seem less likely?
Well, the yield curve starts to look a lot less... curved. Short-term yields and long-term yields can end up having very little difference - if any. Short-term securities may have their interest rates raised by the Federal Reserve. Long-term bonds may see great demand as people anticipate a downturn in the economy, causing their value to drop.
Often, a flattening yield curve can be part of a transitional period - whether as a precursor to an economic struggle, or a rebound from an existing struggle.
Inverted Yield Curve
If a normal yield curve flattening is a sign of problems upcoming in the economy, the curve going below flat and becoming inverted can be a warning sign of an outright incoming recession. In an inverted yield curve, the yield on long-term bonds is actually lower than short-term.
Long-term bonds are bought and sold with much lower yields, as investors feel they're better off waiting and holding onto long-term investments after the storm of a recession has been weathered. Meanwhile, without much demand for short-term securities as a recession potentially looms, their yields go up to try and entice more investors.
As was stated earlier, a yield curve like this isn't necessarily a guarantee of a recession. But it tends to stoke the fears of one very quickly because an inverted yield curve is fairly rare. And more often than not on these rare occasions, that inverted curve preceded a recession.
What Factors Can Change the Yield Curve?
Regardless of what direction the yield curve is going, the factors that affect it are all related. Seemingly, the most important factor is simple anticipation. Signs that the economy is about to do very well or very poorly can bring sudden changes to the curvature.
Whether the action that was anticipated comes true becomes a significant factor as well. Anticipation of an economic upturn can cause a normal yield curve; should it become clear that it really will happen, that yield curve can get a lot steeper, but if expectations are not met, the uncertainty can change it as well. It impacts not only investor outlook, but what the Federal Reserve does to interest rates.