The yield curve is front and center in the news but what does it mean and how does it tell us where we are economically?
The shape of the yield curve gives an idea of future interest rate changes and economic activity.
Normal, inverted and flat. Generically, there are three states of the yield curve and they are each indicative of the current economic climate:
Normal Yield Curve
A normal yield curve is one in which longer maturity bonds have a higher yield compared with shorter-term bonds due to the risks associated with time. This condition is considered "normal" because uncertainty is weighted to the future. "Today is just another day, and I can worry later if things start to falter." This shape of the yield curve is referred to as contango.
Inverted Yield Curve
An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields, which can be a sign of upcoming recession. "I need money now so I can cover my obligations!" Credit is tight, as is access to capital, and one would pay more interest to have the cash on hand. This type of yield curve is said to be in the state of backwardation.
Flat Yield Curve
A flat yield curve is one in a state of uncertainty. "Heads or tails?" It is anyone's guess. Flat indicates that there are issues as far as access to capital is concerned.
So, where are we now? Let's begin to assess recent data. Below is the current state of the U.S. Treasury yield curve.
We have a flat to normal curve. Nothing to worry about, correct? We still have a very low-interest-rate environment and money is cheap. The key, however, is the relationship between the maturities. Look at this graph:
We are at a watershed moment. Economically, we are treading on thin ice. As we discussed above, a flat yield curve is indicative of something that may be afoot. Watching the pure yield of the 10-year note is important; however, the relationship between the 10-year and shorter-dated maturities is more crucial. That will tell us where we are going in the short-run.
Traders need to watch the yield curves as indicators and harbingers for our economic future. The yield curve brings blatant information to light that is easy to decipher and apply to your trading decisions.
Yes, the 2.5 percent yield on our 10-year note is an important level, and going above this level should raise eyebrows, but what is more important is the relationship between the 10-year note and shorter duration instruments. Watch that spread in the weeks ahead. It has ramifications for the stock market, the U.S. dollar and ultimately, the global economy.
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(This article is sponsored and produced by CME Group, which is solely responsible for its content.)
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