By S. Wade Hansen, analyst at LearningMarkets.com
Looking into the Interest Rate Crystal Ball
The yield curve is a favorite market indicator of analysts and investors around the world, but what can it tell us? How can we use the yield curve to analyze current market conditions and project future market conditions?
As you will see in the video, the yield curve can tell us a lot about what investors' expectations for interest rates are and whether they believe the economy is going to be expanding or contracting.
The Yield Curve
The yield curve is a graph that plots the relationship between yields to maturity and time to maturity for a group of bonds. Along the x-axis of a yield-to-maturity graph, we see the time to maturity for the associated bonds, and along the y-axis of the yield-to-maturity graph, we see the yield to maturity for the associated bonds.
When you hear people talking about the yield curve, they are most likely talking about the yield curve for U.S. Treasuries. However, virtually any group of bonds or other fixed-rate securities that come from the same asset class and share the same credit quality can be plotted on a yield curve. For this discussion, we will be referring to the yield curve for U.S. Treasuries.
Slope of the Yield Curve
The slope of the yield curve provides analysts and investors with the important information they are looking for. Typically, you will see one of the following three slopes on your yield curve:
- Normal Yield Curve: A normal yield curve tells us that investors believe the Federal Reserve is going to be raising interest rates in the future. Typically, the Federal Reserve only has to raise interest rates when the economy is expanding and the Fed is worried about inflation. Therefore, a normal yield curve often precedes an economic upturn.
Image of a Normal Yield Curve in relation to the S&P 500 on 17 March 2003---Chart courtesy of StockCharts.com
- Flat Yield Curve: A flat yield tells us that investors believe the Federal Reserve is going to be cutting interest rates. Typically, the Federal Reserve only has to cut interest rates when the economy is contracting and the Fed is trying to stimulate growth. Therefore, a flat yield curve is often a sign of an economic slowdown.
Image of a Flat Yield Curve in relation to the S&P 500 on 9 March 2006---Chart courtesy of StockCharts.com
- Inverted Yield Curve: An inverted yield curve tells us that investors believe the Federal Reserve is going to be dramatically cutting interest rates. Typically, the Federal Reserve has to dramatically cut interest rates during a recession. Therefore, an inverted yield curve is often a sign that the economy is in, or is headed for, a recession.
Image of an Inverted Yield Curve in relation to the S&P 500 on 31 January 2007---Chart courtesy of StockCharts.com
Understanding the Yield Curve: Video Lesson
I've scratched the surface of this topic in the article above, but I go into more detail about what affects the yield curve and how you can interpret it in the Understanding the Yield Curve Video. Click here to watch.
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