The Yield Curve
April 7, 2009

You've heard of it.  You've probably seen one.  But have you really studied how it works and what information it can reveal?  Today, we take a look a the faithful yield curve and discuss how to interpret it.  Understanding this simple tool will give you deep insight to the current phase of the business cycle.

How It's Made
A yield curve is just a simple graph of Treasury yields on the vertical axis and maturity dates on the horizontal axis.  The graph is simple, like you did in high school algebra.  The bottom scale is usually not linear, since it typically ranges from 3 month maturity up to 30 years.  Plenty of examples follow.

Preliminaries
To understand the yield curve, we need to review a couple of concepts:  Required Return and Lending/Borrowing Supply and Demand.

Required Return
Required Return is the yield, or payback, that an investor expects given the level of risk involved.  There are many types of investment risk, such as time risk (Will the bond actually pay out all coupons over time?  Will rates be better in the future?), business risk (Will the company stay in business?), economic risk (Will the economy tank or grow?), exchange rate risk (Will the foreign stock hold it's value relative to the US dollar?), etc. 

All investments have some level of risk.  The higher the perceived risk, the higher returns expected by the investor.  US Treasuries are considered the least risky of all domestic investments since they are backed by the Federal Government.  Compare these yields to those of high-yield corporate bonds (junk bonds), and you see what I mean.  Corporates always pay higher than Treasuries.  This is also why savings accounts pay slightly less than CDs at your local bank.  You can withdraw your savings at any time, but you are committed to a specific time period with a CD.


Lending and Borrowing Supply and Demand
When you buy a bond, you are lending money to the Federal Government.  The return you require depends on inflation, demand for Treasuries, and the length of time the money is loaned. 

When a company needs to borrow money, they borrow from banks, and pay a certain
interest rate.  The more demand for borrowing, the higher the rate paid.  Less demand, lower rates.

The Four Seasons
No, not Frankie Valli, nor Vivaldi, although I like both.  There are 4 general shapes to a yield curve, and they occur for very specific reasons.  Let's take a look at each:

1.  NORMAL
The normal curve is by far the most common.  It shows normal business conditions.  The short-term yields are shorter than the long-term yields.  This is considered normal because of time risk affecting required return.  

With Treasuries, as reflected on the yield curve, the only real risk is time.  To loan your money to the government, you buy bonds.  In return, you expect a profit, or yield, on your investment.  The longer you loan money (higher maturity), the more time risk you are taking on, and therefore would expect a higher yield. 

If bonds are so safe, then why should you get more money back on a long bond vs. a short bond?  The reason is that you are committing your money for a longer period.  This introduces opportunity risk, which says that if your money is tied up in the long bond, you can't use it to invest in better opportunities if they should occur.  If rates go up in the future, you don't participate.


2.  STEEP
This curve is a variation of the NORMAL curve, but the long and short rates have spread out further from each other.  This discrepancy indicates a strong buying, or lending, demand for short bonds (higher bond prices mean lower yields), and a higher perceived risk, and required return, for the long bonds.  This happens often when there is tremendous panic in the stock markets, and often near market bottoms. 

Another way to look at it is that during the business cycle, as recessionary pressures set in, the demand for short-term borrowing by companies, called commercial paper, is very low.  Companies are cutting back spending, laying off employees, and generally not borrowing.  Consumer borrowing also decreases during economic downturns, so demand for loans (auto, credit card, etc.) is low, driving rates lower.

Because of economic uncertainty, the longer-term bonds require higher rates, so the spread from short to long is much wider than in a normal curve.

3.  FLAT
The opposite of the STEEP curve is the FLAT curve.  As business conditions improve, coming out of a recession, the yield curve will pass from the STEEP shape, through a normal shape for the duration of a typical business expansion, and eventually to a FLAT shape.  By the time we see this, we know that the business cycle is starting to get long in the tooth.  This chart has several implications.

First of all, the demand for short-term borrowing is above normal.  Business are doing well, and are driving short-term rates higher by borrowing to expand facilities, hire workers, or whatever is necessary to grow their business. 

Economic uncertainty is quite low, so long-term rates don't demand the required rate of return as they did during the uncertain times (STEEP curve).  Also, bonds are going out of style as stocks are doing so well, dividends are safe, and money flows from fixed income to common stocks.

Another factor influencing general interest rates is inflation.  As the economy improves, commodity prices usually increase, as manufacturing and consumer demand grows.  As the commodity prices go up, short term rates will also go up, indication a level of inflation.

In summary, the FLAT curve occurs as short rates go up and long rates come down.  It's not very common, but should be paid attention to when it does occur, since this can often mean that the economic expansion is getting a bit frothy.

4.  INVERTED
An over-heated economy occurs when business is thriving, commodity prices have risen, and demand for short-term borrowing is as high as it gets.  Short-term yields can actually go higher than longer yields, which is contrary to common sense.

The other factor driving up short rates is that the stock market is typically going gangbusters when we see this curve.  Since so much money is flowing into stocks, bonds are generally way out of favor.  As bonds get sold off, the yields are driven up (remember the inverse relationship between bonds and yields). 

This type of curve is a giant "CAUTION" sign for any economic expansion and bull market.  When demand for borrowing is so high, it can only mean that the economy is about to change directions. 

I can personally remember back in late 1999 and early 2000 when I first heard the term "Inverted Yield Curve".  I didn't know what it meant, only that it was rare.  I tried to determine its significance, but did not have the big picture knowledge to understand that it is directly related to the business cycle.

We got another warning shot in 2007 as the market was making new highs.  As we'll see below, paying attention to this simple indicator could have gotten you out of at least some of your stocks near the October, 2007, high.

Real-Life Example:  The 2002-2007 Business Cycle
The following example uses screen shots from StockCharts.com.  This free resource is invaluable for keeping up with the current curve. 

Each picture shows the yield curve on the left, and the date of the snapshot on the right, along with the point in the stock market for that date (red line).

STEEP Yield Curve at the End of the 2002 Recession
At the bottom of the bear market in 2002/2003, the yield curve was very steep.  StockCharts calls it normal in the curve because they do not distinguish between normal and steep.  Short rates were near 1%, while longer rates were over 5.4%, creating a spread of about 440 basis points.  This support at the high end is related to the housing market, as we will see after the housing bubble bursts in 2005. 


NORMAL Yield Curve During the Business Expansion
Two years later, in April, 2005, we see a typical example of a NORMAL curve.  Notice how much the short-term rates have risen up to 2.8%, indicating an economy on the upswing with demand for short-term paper.  Long rates have remained stable, and the spread is now reduced to 260 basis points (5.4% - 2.8%).


FLAT Yield Curve After Housing Bubble Burst
Skipping ahead one year, we start to see signs of exhuberance.  The chart below shows that short-term rates have risen to over 4%, but the long rate has fallen considerably to 4.7%.  The spread is now less than 20bp, or 0.2%.  The simple reason is that while general business was thriving, and commodity prices were rising, the housing market topped out in 2005.  Short rates (inflationary) went up, but long rates (mortgage demand) came down.


INVERTED Yield Curve After Near End of Expansion


Finally, as 2007 began, we saw consistent appearances of the INVERTED curve.  Housing was on the down slide, but short rates surpassed the long rates by 50bp (5.2% short yield vs. 4.7% long yield).  This was the beginning of the end for the business expansion.

In fact, for the six months starting January 31, 2007, through the end of July, the yield curve was either flat or inverted every single day.  That is significant, and clearly marked the end of the bull market.  Had I been paying closer attention to this important indicator, I probably would have invested differently.  The S&P 500 finally topped out 2-1/2 months later.

 
STEEP Yield Curve in 2008 Panic
Just to complete the cycle, the final chart is the November, 2008 market panic, started in October.  After several NORMAL curves, we've gone back to the STEEP curve, just like in the 2002/03 market bottoms.  This time, the long yield is considerably lower at 4% vs. over 5% before.  This has to do with the housing market, again, as well as the general level of interest rates across the board being lower.
 

CONCLUSION
The yield curve is the missing link between business activity and the economic cycle.  The stock market is forward looking, and generally leads the economy.  However, the yield curve gives us a glimpse inside the business cycle by relating demand for borrowing to inflation and interest rates in general.  Understanding the cyclical nature of the yield curve is critical to understanding the cyclical nature of the stock market, and therefore investing.

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