Yield curve: what is it and what types are there?

We look at the yield curve, its various forms, and how it can help investors.

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Source: Bloomberg

What is a yield curve?

The yield curve is a graphical representation of the gap between interest rates on short and long-term US government bonds, known as treasuries.

In fact, all countries have a yield curve for their bond markets, which plots the interest rates at set points in time for bonds that have equal quality in credit terms, but differing maturity dates. But given the importance of the US to the world economy, it is the American yield curve that commands most attention.

The yield curve provides a graphical representation of investor attitudes towards risks. By assuming that the bonds on the graph are equal in terms of quality and maturity dates (ie when they expire), we can see how investors feel about the outlook for an economy.

How can it help investors?

The US Treasury yield curve is most frequently employed, as it acts as a proxy for risk appetite around the globe. When investors feel confident about the outlook for the economy, they are happy to invest in riskier assets such as stocks and commodities and are unconcerned about holding long-term bonds that offer low rates of capital and income return, relative to other assets. Thus they sell their bond holdings, which causes the yield to go up (bond prices and yields move inversely).

Types of yield curve

The concept of a yield curve is to provide an indication of future changes in interest rates and economic growth. Yield curves come in three types:

  1. Normal yield curve – those bonds with longer maturities have higher interest rates than short-term ones, as the risks associated with holding bonds over a long period of time, such as inflation, demand that the income received (the ‘yield’) is higher. Bond investors are signalling that they expect economic growth to continue without major interruptions, and are thus happy to commit to funds for the longer term.
  2. Inverted yield curve – shorter-term bonds have higher yields, as investors are concerned about the near-term outlook and thus demand a higher income for holding these shorter-maturity investments. Lower interest rates tend to mean weaker economic growth, and an inverted yield curve can signal a recession is near.
  3. Flat yield curve – both short and long-term yields are at similar levels, suggesting that the economy is in a transition period, either from growth towards recession, or recession to growth. In the former, short-term yields rise, and longer-term ones fall, while in the latter the reverse is the case.

What do yield curves signal?

Yield curves are most often discussed in relation to the US economy and its government bond market, since it is the largest in the world, and its direction usually sets the tone for others. A flattening US yield curve suggests the bond market has become more pessimistic about future growth.

The St Louis Federal Reserve maintains a chart of the ten-year Treasury yield minus the two-year Treasury yield, which shows when the curve inverts and falls below the zero line.

An inverted yield curve occurs ahead of each of the US recessions in the past 40 years, and thus should be viewed as a useful indicator for the outlook. It is important to note that the yield curve inverts at least a year ahead of a recession, and thus it is more of a warning signal that flashes amber once an inversion takes place, rather than immediately flashing red.

The inversion of the yield curve is usually something that makes market reporters and financial news channels very excited, since the common view is that it means a recession and/or a bear market (or perhaps both) are just round the corner.

In fact, the data suggests that the S&P 500 gains by a median of 6.6% during the flattening of a yield curve, and that we should be cautious about suggesting that an inverted yield curve is a harbinger of economic doom.

Ways the yield curve moves

As well as the three types of yield curve, we also have four different regimes for the yield curve:

  1. Bear steepening – interest rates are rising, and the yield curve is steeper
  2. Bear flattening – interest rates are rising, and the yield curve has flattened
  3. Bull steepening - interest rates are falling, and the yield curve is steeper
  4. Bull flattening - interest rates are falling, and the yield curve has flattened

Research from Blackrock shows that a bear steepener regime is the most benign environment for equities, with an overall return of 10.9% for the S&P 500 in an average six-month period, as rising interest rates and a belief that growth will rise and inflation will remain steady. Meanwhile, a bull steepener is the worst, as the Federal Reserve (Fed) eases monetary policy and investors fret about growth. The average six-month return for the S&P 500 is -5.5%, with most sectors weaker and only those viewed as risk-off (such as consumer staples and utilities), seeing a positive average six-month return in this period.

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The yield curve is a handy way of looking at investor risk appetite, and the view of the bond market on economic growth. It is not an exact predictor of whether a bull market is likely to continue or turn into a bear market, but overall it is a good starting point for those looking to gauge whether more economic expansion is likely.

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