Monday, November 29, 2004

The Yield Curve, Part I

I’m sure most of you have heard the term “yield curve” before but never really understood its meaning or what it can show you. I am going to try to explain exactly what the yield curve is, what it does, and how you can use it for long-term investing. You will want to remember this article in a few months…trust me.

You can find the yield curve every day here at Yahoo Finance.

Basically, the yield curve is a line graph that plots the different yields for bonds of differing maturities. The shorter the maturity, the lower the yield…usually. The longer you hold a bond, the riskier it is since you don’t know what is coming around the corner. Investors will want a higher yield (rate) to compensate for that risk. So, the “normal” shape of the yield curve is upward sloping. There are some instances where the yield curve can slope downward or invert, but those times are relatively few and far between.

Investors want to pay attention to the yield curve because it has historically been a good leading indicator of what is to come in economic activity. A steep upward sloping curve usually precedes an economic upturn. A flat yield curve frequently signals an economic slowdown. An inverted curve can mean a recession is just around the bend.

How does the yield curve tell us all of that with just a line? Well, that line represents a few things. The yield curve’s shape is based on two major factors: investors’ expectations for future interest rates and “risk premiums” that investors require to hold long-term bonds.

Using the above paragraph as a guide we can now interpret what the different shapes of the yield curve mean. An upward sloping yield curve (good economic activity ahead) says that interest rates will begin to rise quite a bit in the future. Investors will therefore demand more yield (interest) the longer they hold the bond due to the increased risk of higher inflation and interest rates.

Click to Enlarge Posted by Hello

The flat yield curve (economic slowdown) usually occurs during the transition from one of the sloping curves to the other, i.e. upward sloping to downward sloping and vice versa. The flat yield curve usually shows up when the Fed is raising interest rates to constrain a rapidly expanding economy. So, short-term yields rise to reflect the new rate hike. Long-term rates fall as investors are now expecting inflation to come down since the Fed is putting on the economic breaks.

Click to Enlarge Posted by Hello

The downward sloping, or inverted, yield curve (recession) is the worst curve a bullish investor wants to see. An inverted yield curve usually is telling you that a recession is not too far away. This curve suggests the exact opposite as the rising yield curve. When you see a downward sloping yield curve, investors expect interest rates to decline in the future. Declining interest rates usually occur in conjunction with a slowing economy and lower inflation. Historically, the yield curve has become inverted 12 to 18 months before a recession.

Click to Enlarge Posted by Hello

My next yield curve article will contain some actual academic studies for us to look through so you know that I am not just filling my web space with hot air.

Best Regards,

The Soothsayer of Omaha


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