Curves can often grab our attention. Whether it’s our own expanding curves after a few too many Christmas cookies, a sudden curve in the road, or a curveball request from the boss. In investing, the yield curve deserves your attention too. It can help you understand your options as an investor and the health of the overall economy.
What is the yield curve exactly?
Simply put, the yield curve is a line that plots the interest rates of bonds with different maturity dates. The most frequently reported yield curve compares the two-year, five-year, 10-year, and 30-year US Treasuries.
When you plot the interest rates of US Treasuries of different maturities on a chart, it forms a curve — the yield curve. And the shape of this yield curve can give you an idea of future interest rate changes and economic activity.
What does bond maturity mean?
A bond’s maturity date is the date on which its principal amount (the amount the bondholder paid for it) becomes due and is repaid to the bondholder, and interest payments stop.
Flattening yield curve: the long and short of it
In a “normal” yield curve, short-term yields are lower than long-term yields, because as an investor (borrower) you would expect to be compensated for taking on more risk in the form of longer bond maturity. Bonds with longer maturity would typically come with more risk as there is a greater chance for default or for the value of the bond to decrease due to economic events.
However, in the last year (as you can see on the chart below), interest rates with very short-term maturities (2-Year) have risen significantly, while those with longer maturity dates (10- and 30-Year) have risen only slightly. This means that the yield curve has “flattened,” and it’s not an unusual pattern during the later stages of the business cycle. Why is this?
Interest rates with shorter maturities are directly affected by the Federal Reserve. At this stage in the business cycle, the Fed is raising interest rates to help make sure the economy doesn’t overheat (which increases inflation risk). As such, we can clearly see the “short end” of the yield curve rising over the past year in the chart above.
The “long end” of the curve has been rising at a much slower pace. This part of the curve is more influenced by long-term economic growth and other factors, such as supply and demand, investor sentiment, inflation, and global forces. With significant uncertainty in the global economy and markets at the moment, these rates have stayed put.
A “flattened yield curve” is typically what happens naturally as our economy approaches the later stages of the business cycle. The current business cycle is the second longest cycle in US history, and so it’s not surprising that the curve is flattening.
This chart shows the U.S. yield curve today and one year ago. The yield curve has “flattened,” a classic sign that we are in the later stages of the business cycle.
What does this mean for investors?
Many interpret the flattening yield curve as a signal that the bull market is ending and economic growth is slowing, but a flattening yield curve is also an indication that investor uncertainty is on the rise.
While higher rates may be helpful to investors who need portfolio income, the fact that they could also indicate that we’re later in the business cycle means that investors should stay balanced among long- and short-term bonds and stocks. Holding a diversified portfolio and maintaining investment discipline are likely to be the best ways to invest as the yield curve continues to flatten.