Deconstructing Yield Curves

Yield curves are a snapshot of bond yields of similar credit quality and asset class, ranging from maturities of as little as one month to 30 years.

The short end of the yield curve is primarily determined by a central bank's monetary policy and market expectations of future policy. Monetary policy is shaped by interest rate announcements, open market operations (buying and selling of government securities to manage liquidity), bank reserve requirements and central bank rhetoric.

The longer end of the yield curve is partly determined by the auctions that governments use to make the initial sale of 5- to 30-year bonds to banks. Once these bonds are resold in the secondary market, their supply and demand determines prices and yields. Bond yields are also influenced determined by traders' assessment of the economy, with inflation being the main economic determinant of their price and yield. Rising expectations of inflation or an actual increase in inflation outstrips the fixed income of bonds' coupon payments, thereby reducing the value of the bonds and boosting their yield to maturity. The same applies during releases of stronger than expected economic reports, which increase the risk of inflation. Conversely, falling inflation and/or weak economic reports are usually favorable for bond prices and negative for their yields.

MEASURING YIELD CURVES can be done through the shape or steepness of the yield curve, which is determined by the difference between selected short- and long-term interest rates. A popular measure is the difference between yields on 10- and 2-year government securities, known as the 10-2 spread. In the case of the United States, another viable measure is the difference between the Fed funds rate and the 10-year rate, where the Fed funds rate is the overnight rate charged between commercial banks.

The time value of money states that bonds with longer maturities pay higher interest rates than bonds with shorter maturities. Creditors willing to lend funds for longer periods of time will demand higher interest rates than those willing to lend for shorter durations. As a result, the shape of the yield curve is positively or upward sloping in normal economic conditions.

Upward-sloping yield curves have normally preceded economic expansions as bondholders demand a higher rate of return from the inflationary risks accompanying economic upturns. The buildup of an upward-sloping curve can be a result of worsening economic conditions, which were initially priced in a flatter yield curve. As economic/market conditions deteriorate and the risks of an economic downturn accelerate, bond traders send short-term rates lower, pricing incoming central bank rate cuts.

Flat yield curves can signal either an approaching economic slowdown or expansion, depending on which stage of the economy had initially prevailed. During economic expansions, central bank rate hikes lift the short end of the curve to the extent of possibly matching the long end of the curve. But prolonged central bank tightening may cause bond traders to expect slower growth ahead, and thus, lower inflationary pressures.

Sometimes, however, yield curves emerge when the economy begins to recover from a slowdown or recession. At this stage, bond traders become certain that the economy has bottomed and start to project higher inflation and interest rates in the distant future, thereby raising long-term yields. It is rare that yield curves stay flat for more than a week as the economy emerges out of a downturn

Inverted yield curves usually signal economic slowdowns and are often a harbinger of recessions. The negative slope of the yield curve shows that short-term yields are higher than long-term yields as bond traders expect lower interest rates ahead. Many economists have disputed the validity of the yield curve as a predictor of recessions and economic slowdowns. Of the eight U.S. recessions between 1957 and 2008, only the first two recessions (1957-1958 and 1960) were not preceded by an inverted yield curve. And out of the eight occasions (including 2006-2007) when the yield curve was inverted since the 1950s, only twice were the inversions not followed by recessions: 1966 and 1998. The exceptions of the 1950s and 1960s may be discounted due to the relatively low levels of depth and size of financial markets 50 years ago, and the different mechanism by which the Fed managed monetary policy at the time. Nonetheless, in each of the aforementioned inversions, the Federal Reserve was forced to cut interest rates, which is the primary focus of this section and chapter 6 of my book.

Historically, yield curve inversions have started about 12 to 18 months before a recession. The main reason inverted yield curves have presaged economic weakness is that they narrow the premium gained by banks between the short-term interest rates paid out to depositors and the longer-term interest rates earned on loans. But interest income has become a smaller share of banks' overall income amid the creation of several financial products, which have made non-interest-rate income a bigger share of banks' total profits. The rationale of why yield curve inversions imply slower activity also extends to bond trading and homeowners, but this is covered in more detail in chapter 6 of the book. The chapter also illustrates real life examples of the various shapes of yield curves.