Turn on the television or browse the internet, and you’ll see there’s no shortage of opinions about what’s next for the economy.
But if you’re tired of opinions and want to learn about what economic indicators are saying about the economy, it’s time to check out the yield curve.
Simply put, the yield curve shows investors’ appetite for risk with their money. There’s no emotion or judgment with the yield curve. It’s simply a graphic representation of the yields available for bonds at different maturity dates.
Changing Yield Curve
What’s critical to understand is that the yield curve is constantly changing as new economic reports become available that influence investors’ assumptions about risk. For example, today’s yield curve looks much different than it did in March 2020, when the pandemic started to grip the nation. And several years from now, the yield curve might look much different than today.1
Remember that the market value of a bond will fluctuate with changes in interest rates. As rates rise, the value of any existing bond typically falls. If an investor sells a bond before maturity, the bond may be worth more or less than the initial purchase price. By holding a bond to maturity, an investor will receive the interest payments due plus the original principal, barring default by the issuer.
“The thief comes only to steal and kill and destroy; I have come that they may have life, and have it to the full.” John 10:10
In 2023, the yield curve remained inverted, meaning that short-term interest rates are higher than long-term rates. That seems a bit counterintuitive. Why would a long-term investor settle for less money than a short-term investor, who is assuming less risk with a bond that matures in a shorter time period? Because the long-term investor is concerned about the economic outlook and they want to lock in an interest rate because they fear rates could go even lower if the economy continues to slow.1
A normal yield curve is when short-term bonds have a lower yield than long-term bonds. When the economy is expected to expand, the yield curve has an upward slope. Investors are thinking that the longer they commit funds, the more they should be rewarded since they invested in a longer bond and they are unable to use the money in other shorter-term tools.1,2
Think of a flat yield curve as the transition phase between the other two curves. When the outlook for the economy is uncertain, there may be little difference between the yield on short-term bonds and long-term bonds. When the curve is flat, there’s no additional compensation for the risk of holding a longer-term bond.3
It’s important to remember that the yield curve for U.S. Treasuries is the one that is most often discussed, but the yield curve can be applied to other types of bonds too.
As we create portfolios, we listen to what the yield curve is saying about the economy, but we focus on your goals, time horizon, and risk tolerance. We treat the yield curve as one piece of information as we consider our overall economic outlook.