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The yield curve is a simple financial chart or graph. The chart shows investors from around the world what to expect in the future from the US Federal Reserve. It also shows the effects the reserve will have on US interest rates, economy and inflation. A yield is commonly defined as a crop or harvest; in this case the harvest is financial.
The yield curve shows the present yields of the Treasury's securities at different stages of maturity. From 30 year T-bonds to 3 month T-bills, future expectations can be plotted on the yield curve chart. People who work in the field of finance, such as bond investors, analyze the yield curve and try to work out its meaning for the future. Using the chart, bond investors try to work out different yields expected on short-term securities compared to long-term ones.
Long-term maturities usually have higher yields than short-term ones; this is seen as a normal yield. As this is the norm, it is shown on the chart as a positive slope. The curve is inverted on the chart when the opposite applies, and short-term maturities give out a greater yield. The Federal Reserve controls short-term interest rates; this is why short-term maturities give out a lower, longer yield.
The shape of the curve on the yield curve chart holds a variety of meanings for bond investors, but there are two basic ways of viewing it. If the shape of the curve is positive, then it is expected that the Federal Reserve's monetary position will be friendly towards the financial market. A friendly financial position is good for the economy, and stocks and shares. Therefore, if the yield curve on the chart is steep, it is a good sign for investors.
If the slope is negatively curved or inverted, this indicates that the Federal Reserve's stance is unfriendly. The Federal Reserve will be engaged in a strategy to try to slow the economy. They do this by raising short-term interest rates. In general, this indicates a poor set of conditions for the market and the economy.
Research has shown that the yield curve is a better predictor of the economy than studying the stock market. The yield curve has the ability to predict economic events around 12 months in advance. The stock markets can only predict six to nine months in advance. If you study the yield curve, it may give you an information advantage when buying stocks, shares and securities.
@NathanG - A yield curve is nothing more than a trend. Everyone watches trends, and trends for the most part predict the direction of things as they stand now.
Yes, trends can reverse course, but there are usually hiccups along the way that signal a change in direction before it actually happens.
I bought some corporate bonds some years ago and when I reviewed the company prospectus, I looked at the charts. I happen to love charts, and a steep corporate yield curve is a thing of beauty indeed. It kind of reminded me of graph plots I used to do in school.
Anyway, the charts were good, the stars were aligned, and most of my bonds did
well over time. However, one of them tanked about ten years later when the company filed for bankruptcy.
Looking at the chart the first day would not have predicted that, but reading the quarterly reports would have. That’s one thing I didn’t always do.
@NathanG - I think yield curves do predict the future, but you need to remember the horizon. We’re only talking 12 months out at the most.
You can’t expect it to tell you what will happen three or five or ten years out, because the Federal Reserve policies may change in that time frame. These are meant to be short term tools and I find them useful when weighing my investment options.
As for remembering a time when Federal Reserve policies were not always good for the economy, perhaps I am a little older. I remember when the Feds lowered interest rates in the early 1990’s, triggering massive transfers of funds from government securities into the stock market.
Then, nearly a decade later, the Federal Reserve reversed course and started raising rates. I wasn’t watching charts back then, but I’m sure any upward sloping yield curve up until then suddenly switched directions when policies changed.
Everyone wants to know what will happen in the future. If a yield curve is a better predictor of that than anything else, as the article suggests, then I suppose it’s in our best interest to understand it.
The problem I have is that I have rarely, if ever, seen an inverted government yield curve, which would signal that the Federal Reserve is taking monetary measures that would hurt the economy.
Now it may be that I have not been an investor long enough, and that I have not spent enough time analyzing the charts, but that has been my experience.
Personally, I take these suggestions that this or that tool or graph will accurately predict the future with a grain of salt, but I do find the graphs interesting in the same way that I find stock market charts interesting. Stock market charts fare no better at predicting the future either in my opinion.