Yield curves offer insight into the current economy and forecast future conditions. Josh Answers, the host of, The Trading Fraternity and The Stock Market Live, says that while these graphs are not “crystal balls,” they are still valuable sets of data well worth looking into.
“Yield curves are just indicators,” he says, “but they’ve hit the nail on the head in the 10 most recent recessions. Wise investors keep an eye on them, and I will never ignore it”
What is a yield curve?
Any type of bond reveals a yield curve. Governments and companies sell bonds to raise money by borrowing from investors. Treasury bonds, also called T-bonds, are backed by the US government and considered risk-free. Local governments such as cities and states issue municipal bonds to raise capital for projects like schools, roads, and hospitals.
When people purchase a bond, they actually provide a loan for the issuer of that bond. When their bond matures, they are repaid along with a predetermined rate of interest. This interest is known as the coupon. The coupon on a bond won’t fluctuate, but the yield will. Investors can think of yield as the coupon amount divided by the bond’s price — when the price changes, the yield changes.
“Any investor should pay attention to the bond market,” Josh Answers remarks. “The bond market is fantastic at predicting where inflation and the economy are headed. Those factors directly influence the prices of stocks, real estate, and everyday items like bread or gallons of milk. Wrapping your head around the yield curve can give you insight into a wide range of investing decisions.”
What can investors learn from the yield curve?
The yield curve shows how the majority of market players see the economy. If they are nervous, most investors prefer to put their money in long-term bonds. This causes short-term yields to rise. Short-term yields also increase when the Federal Reserve hikes interest rates because the rate has a massive impact on bonds that mature more quickly.
During times of normal economic expansion, short-term yields are low and long-term yields are high. When the opposite happens, the yield curve inverts. An inverted yield shows long-term interest rates that are less than short-term rates. As the maturity date becomes farther out, the yield decreases.
“When economists see graphs trending this way, they tend to batten down the hatches for recession, but oftentimes the rest of the market just ignores it as no immediate carnage arrives,” says Josh Answers. “Currently, we are seeing a significant inversion of the yield curve on the two-year and ten-year segments”
A true inverted yield curve is rare, with a flattened curve being a far more common occurrence. A flattened curve indicates a volatile economy that could either trend toward expansion or recession. “The message that the inverted yield curve sends is that people are willing to get paid more interest for a shorter time frame than a longer time frame, and that is wacky. This means people see more risk in the short term than the long term”
Does the inverted yield curve mean recession is inevitable?
“An inverted yield curve often indicates that a stock market drop is on the way,” Josh Answers says. “The yield curve doesn’t cause downturns; it simply illustrates how most investors view the economy. When people fear a slump, they run out to buy long-term bonds. When they all do this at once, the yield drops. The Fed keeping interest rates high ahead of a recession keeps short-term yields higher, which in turn inverts the yield curve.” It’s a hotly debated issue, but my take on it is that the recession comes after the curve is un-inverted after being inverted for some time.
To summarize, there are three types of yield curves: normal, inverted, and flat. Normal yield curves that slope upward indicate economic expansion. Inverted yield curves sloping downward indicate economic recession, while flattened curves indicate uncertainty.
“Yield curve rates are published on the US Treasury’s website every trading day,” Josh Answers clarifies. “This data is an important piece of the puzzle. As you consider financial strategies, look at the yield curve in combination with inflationary trends, the direction of the job market, wage growth, and word from the Federal Reserve. With relevant information in hand, you will be ready to make better-educated guesses concerning the economy’s future.”
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