The Yield Curve Explained
A: I saw this YIELD CURVE EXPLANATION on the sidebar of a recent CNN Money article last night and I immediately knew it would be perfect if I transffered the meat of the article into a post on UrbanDigs. For sake of ease, here is an explanation of the yield curve, and what surrounds all the recent talk of an inverted yield curve!
Lets get right into it. The yield curve is what economists use to capture the overall movement of interest rates (which are known as "yields" in Wall Street parlance).
NORMAL YIELD CURVE
Normally the longer you lend somebody money, the more money you want back in return. After all, more time means more risk. So longer-term bonds typically command higher rates of interest than short-term notes and bills. The resulting yield curve -- a graphical representation of the rates of return for short-term to long-term Treasuries -- rises from left to right.
TYPICAL MOVE
When the Fed starts raising or lowering its target for an overnight bank lending rate -- essentially moving the "short" end of the yield curve -- the entire curve typically moves as well.
FLATTENING YIELD CURVE
Recently the Fed has been raising short-term rates. But long-term Treasury rates have been falling. This has led to a "flattening" of the yield curve, where the difference between short-term rates and long-term rates becomes less and less.
INVERTED YIELD CURVE
If short-term rates continue to rise and long-term rates refuse to do so or head even lower, the yield curve will "invert" -- an unusual state when short-term rates are higher than long-term rates. This is often taken as a sign of impending recession. But debate has grown in recent months over whether this is in fact a reliable indicator. The last time the yield curve inverted was in 2000, and a recession followed. The same thing happened in 1989. But an inversion in 1998 proved to be a false alarm.
This yield curve theory is important to understand because there are always things that can be learned from CAUSE & EFFECT. For example, when the yield curve inverts a recession is looming ---> if a recession is looming the fed will cut rates ---> as rates fall the housing market will runup.....and so on and so forth. After all, having a general understanding of where monetary policy is headed can be very advantageous when formulating a future investment strategy!
It's NOT an exact science but it does tell a story that has resulted in some kind of scenario that could be educational for future analysis. It is true that every recession had an inverted yield curve years before to predict it. However, not every inverted yield curve predicted a recession. Confusing right. Well like I said, its not an exact science. The reason it was big hoopla when the yield curve inverted months back was because if a recession did actually occur than the fed will not raise rates by that much and will actually need to start cutting rates once the data proves a recession is at hand. If rates go down, housing becomes more attractive an investment as CD's, Money Markets, and other fixed investment vehicles become less rewarding.
SmartMoney.com Article: Inverted yield curves are rare. Never ignore them. They are always followed by economic slowdown - or outright recession - as well as lower interest rates across the board.
I hope the graphs above make sense so that now you know what the experts are talking about when they discuss the yield curve, bond rates, and what it could all mean down the road. Lets see how accurate this past inverted yield curve actually turns out to be.
~ Big Rally in the Bond Market
~ The Living Yield Curve
