It seems like everyone is talking about the yield curve these days. But for good reason. It could foreshadow the future market conditions. And lately, it's not showing the prettiest picture.
The yield curve is basically a graph that charts the amount of money you'll get back if you buy a treasury security, and thereby loan the government your hard-earned money.
The yield, a.k.a. the interest rate, you're getting on your loan goes on the up-and-down Y axis. The duration -- or amount of time you are giving up your money -- goes along the bottom, on the X-axis.
Now if you start to actually plot the interest rates on these treasuries, you typically would create an upward slope.
And that makes sense. Because for shorter times -- or durations -- like say you bought a 3-month Treasury bill - you wouldn't expect a huge interest rate in return.
But if you bought a 30-year Treasury bond, you definitely would want a higher rate of return because you're giving the government your money for 30 YEARS and a boatload of things can happen over that time. So you need to get paid extra for taking that risk.
Here's a big note on that interest rate. It's annualized, which means it's the rate for the year. So if you are getting 6% on a 1 month T-bill - your yield essentially is one-twelfth of 6%.
So why do we care about this silly chart? Well it historically has reflected the market's sense of the economy. So if its upward sloping, the market thinks things are going to be good or better in the future.
But once it starts to flatten - or even invert - where the yields are higher short-term than long-term - that doesn't bode well for the future.
As a matter of fact, the curve was inverted before the past 7 recessions.
So why does that happen to the curve? Well, a few reasons. When the Fed starts raising short-term rates, it means they think the economy is starting to overheat and wants to slow it down. Higher rates hurt economic expansions. And also its about investor expectations, especially if they start to become negative. Then they start to buy up long-term bonds and that could depress the yields a few years out.
And so what's happening today? It's really just beginning to flatten now -- so we have time -- but you need to pay attention to it all.
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