The Yield Curve

Study Notes:

The yield curve shows yields or rates of interest on U.S. treasury bonds across different maturities such as the six-month, ten-year and thirty-year maturities. The yield is the annualized return received through interest payments that a new buyer of bonds can expect upon purchasing if the bond is held to maturity. The U.S. Treasury Department bases the yield curve report on bond yields in the open market and is updated each weekday; historical data is also available. The U.S. Treasury Department wants a strong economy and publishes daily yield curve statistics so that Congress, policymakers, market participants and business leaders can have timely and reliable information concerning U.S. Treasury bonds.

When the U.S. government needs funds to cover expenses, selling treasury bonds at auctions is a way to raise cash. The buyers of treasury bonds receive interest payments; buyers include central banks, insurance companies, foreign governments, companies, banks, investment funds, individuals, etc. If interest rates are generally higher across the curve, that means the government needs to pay more in interest when it issues bonds; higher rates benefit lenders at the expense of borrowers, in this case the government is the borrower.

The yield curve is influenced highly by the Federal Reserve, the American Central Bank. It sets short-term interest rates in the U.S. which influence the shorter-dated maturities. It also buys and sells bonds across all maturities, influencing yields across the curve. Market participants also influence the yield curve as a surplus of buyers would lead to increases in bond prices while a surplus of sellers would lead to decreases in bond prices. Bond prices move inversely to yields.

The curve gives us important insights regarding expectations for economic growth. It helps us understand where we are we in the economy and where we may be headed. Due to the time value of money, typically it costs more to borrow money for a longer period of time. The yield curve is normally positively sloped, implying that it costs more to borrow for longer time periods than it does to borrow in the short term. When the yield curve steepens, the cost of borrowing at far-dated maturities rises by more than the cost of borrowing in the short-term.  This usually implies strengthening economic growth or inflation.

A flat yield curve that has similar yields across all maturities implies that there’s economic uncertainty on the horizon.  Should longer rate maturities decline such that they are lower than shorter rate maturities, the yield curve is said to have inverted. A yield curve inversion is a classic recession indicator that can predict contractions in economic activity.

The natural forces of lending suggest that markets are in balance when lenders receive more yield for more duration. An inverted yield curve signals market imbalances that will likely lead to economic weakness, lost jobs, falls in tax revenue, falls in investment and falling production. When market participants disagree with the Federal Reserve’s policy on rate-setting and bond purchases, distortions and inversions across the curve can manifest.

If the yield curve inverts in the U.S. like it did prior to the 2008 financial crisis and the 2020 COVD-19 recession, economic consequences as well. The global economy depends a lot on the health of the U.S economy as it makes up roughly a quarter or 25 percent of global economic activity. Amplifying impacts, the U.S. is the largest importer in global trade, carries a trade deficit, and issues the world’s reserve currency. Economic weakness in the U.S. will likely spread globally and weigh on international economies. Global declines in company revenue, tax revenue, employment and economic activity are expected when the U.S. economy is in recession.

Events that might cause the yield curve to change shape and slope include government budgetary decisions in Congress, investor demand at treasury auctions, short-term rate setting and bond transaction news at Federal Reserve policy-setting meetings, and leading economic reports including retail sales, inflation, employment, industrial production and GDP.

The yield curve inversion has preceded the last six out of six recessions. The differences in yields across the yield curve provide incredibly useful information concerning prospects for economic growth or prospects for economic contraction.