I listen to a great NPR podcast called Planet Money. It takes various aspects of the economy and explains them in a fun, down to earth way. I highly recommend it.
One of the things they talk a lot about on Planet Money is the yield curve. I’d never heard about the yield curve before listening to Planet Money, but it’s a key economic indicator that can help forecast if a recession is imminent! Today, I’m going to tell you about:
- What the yield curve is
- What the shape of the yield curve means
1. What the yield curve is
The yield curve is just a line – but it’s a very important one. It shows the yield or interest rate that is associated with securities that have the same credit quality, but different maturity dates. Credit quality is basically what it sounds like – it lets you (the investor) know how high the risk of default on the bond. A maturity date is when a bond comes due – that is, when the investor will get the money back they put into the bond!
Typically, bonds with longer maturities – those that require investors to wait longer before redeeming them – pay more than those with shorter maturities.
The most common way to determine a yield curve is with U.S. Treasury securities. The following is taken into consideration when building a yield curve:
- Having securities with similar characteristics – such as risk. For U.S. Treasury securities, the risk is generally low
- The interest rate for a series of bills or bonds – anything from a six-month Treasury bill to a twenty-year bond
2. What the shape of the yield curve means
The slope of the yield curve gives an idea of future interest rate changes and economic activity. There are three main types of slopes:
- Normal – an upward sloping curve
- Interveted – a downward sloping curve
- Flat – there is no slope
Normal yield curve
In a normal or upward sloping curve, longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time. A normal yield curve is the most common yield curve shape – it is often referred to as the “positive yield curve.”
Inverted yield curve
An inverted yield curve occurs when shorter-term yields are higher than the longer-term yields. This kind of yield curve can be the sign a recession may occur in the near future.
Flat yield curve
In a flat yield curve, well – there’s not much of a curve! A flat yield curve occurs when short-term and long-term rates for bonds of the same credit quality are basically the same. Like the inverted yield curve, a flat yield curve can often be the sign of an approaching recession.
So now what?
Now you know a key indicator in investing – the yield curve! You can keep an eye on it to determine where it seems like the economy is heading. If it looks like a recession may be imminent, it may time to rebalance your portfolio!