Bond Basics: How to Read the Yield Curve

This lesson was written by Stockpickr member Ira Krakow.

If you did the homework assignment in " The Basics of Bond-Picking: Pricing and Quotes," you would have discovered that, in general, the yield to maturity of a bond increases as the maturity date goes farther into the future.

In a normal situation, you should be paid more interest when you hold a bond for a longer a period of time. Why? You're taking the risk that bond prices could fall (which means interest rates could rise), over a longer period of time.

So what is the often discussed "yield curve" all about?

The yield curve is simply a graph of the relationship between interest rates and maturity dates. Here's the current Treasury yield curve, from Bloomberg:

Click here for larger image.

When bond yields are increasing over time, the yield curve is said to be "normal." Even though there are a lot of things that aren't normal in the financial markets these days, one thing that is normal right now is the Treasury yield curve, because yields steadily increase as the maturity date lengthens.

According to the Daily Treasury Yield Curve Table, as of June 11, 2008, the yield to maturity on 2-year Treasuries was 2.83%, increasing to 3.49%, 4.10%, 4.76%, and 4.72% for 5, 10, 20 and 30-year Treasuries, respectively.

As an investor in the stock market, why should you care about the yield curve?

The reason is that the yield curve theoretically tells us whether the market is expecting economic growth, stagnation or a slowdown.

A normal yield curve should be good for the stock market. If the economy is growing, bond investors expect accompanying inflation, which increases the risk of higher interest rates. Bond investors expect to be rewarded more, in the form of higher yield, for taking on this risk. They're betting that the Federal Reserve will raise interest rates to control inflation.

Can the Yield Curve Predict the Next Recession?

The yield curve changes its shape -- sometimes dramatically,-- over time. A great way to see this is to go to StockCharts.com's Dynamic Yield Curve. If you click on the "Animate" button, you can see how the yield curve's shape changed since the beginning of 2002.

When short-term yields are higher than long-term yields, the yield curve is said to be "inverted." In an inverted state, bond investors are essentially betting that the economy will slow, causing the Fed to lower rates to stimulate growth. They will prefer shorter term bonds over longer term bonds. According to the Federal Reserve Bank of New York's Website, the shape of the yield curve can predict a recession.

If short term and long term yields are roughly the same, the yield curve is called "flat." In that case, bond investors are predicting that the economy will be stagnant.

Having Fun With the Dynamic Yield Curve

Let's see if the shape of the yield curve actually can predict how the economy will perform over the next year.

Step 1. Go to StockCharts.com's Dynamic Yield Curve. On the right of the screen is a graph of the S&P 500 from April 2000 to June 2008. When you click on a point on the S&P 500 graph, the yield curve at that time displays on the left.

Move the vertical red line across the S&P graph and observe how the yield curve changes.

Step 2. See whether the shape of the yield curve at the beginning of the year predicted the S&P average at the end of the year. Start on January 9, 2001, the first point at the beginning of 2001. At that time, the S&P 500 was at 1,342.90, as shown below:

Click here for larger image.

Given the shape of the yield curve - it looks fairly flat - how do you think the S&P should have performed during 2001? What would you have predicted for the index at the beginning of 2002?

Step 3. Let's go forward in time to January 9, 2002. Were you able to predict the decline in the S&P 500 to 1,155.10 from the shape of the yield curve at the beginning of 2001? Here is what the yield curve looked like at the beginning of 2002:

Click here for larger image.

Step 4. Repeat this analysis for each year from 2002 to 2008, noting the yield curve's shape and the S&P price. Is there any consistency between the shape of the yield curve at the beginning of the year and the S&P index at year end?

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