The U.S. Treasury “yield curve” compares the yields of short-term Treasury bills with long-term Treasury notes and bonds. The U.S. Treasury Department issues Treasury bills for terms less than a year. It issues notes for terms of two, three, five, and ten years. It issues bonds in terms of 20 and 30 years. All Treasury securities are often called “notes” or “Treasury’s” for short.
There are three types of yield curves. They tell you how investors feel about the economy. For that reason, they are a useful indicator of economic growth.
A normal yield curve is when investors are confident, and shy away from long-term notes, causing those yields to rise steeply. That means they expect the economy will grow quickly. What does this mean to you? Mortgage interest rates and other loans follow the yield curve. When there’s a normal yield curve, a 30-year fixed mortgage will require you to pay much higher interest rates than a 15-year mortgage. If you can swing the payments, you’d be much better off, in the long run, trying to qualify for the 15-year mortgage.
A flat yield curve is when the yields are low across the board. It shows that investors expect slow growth. It could also mean that economic indicators are sending mixed messages, and some investors expect growth while others aren’t as sure. When the yield curve is flat, you aren’t going to save as much with a 15-year mortgage. You might as well take the 30-year loan, and invest the savings for your retirement. Better yet, apply the savings against the principle and look toward the day you can own your home free and clear.
A flat yield curve means that banks probably aren’t lending as much as they should. Why? They don’t receive a lot more return for the risks of lending out money for five, ten or fifteen years. As a result, they only lend to low-risk customers. They are more likely to save their excess funds in low-risk money market instruments and Treasury notes.
An inverted yield curve is when short-term yields are higher than long-term yields. It’s an unusual situation where investors demand more yield for the short-term bills than they do for the longer-term notes and bonds. Why would this happen? They expect the economy to do worse in the next year or so and then straighten out in the long run. That’s why an inverted yield curve usually forecasts a recession. In fact, the yield curve inverted before both the 2000 and the 2008 recession.
Many market participants have pointed out that the bond market does not appear to share the equity market’s enthusiasm. As the S&P 500 rises to record highs, the 10-year Treasury yield has remained at rather low levels and is actually significantly lower on the year. This is all the more surprising given that short-term yields have risen as a result of the Fed’s rate hikes, so that the “yield curve” has flattened meaningfully.
The bond market appears to be saying that economic growth will not be particularly strong, particularly in the medium term an apparent rejection of the optimism that is being baked into stock prices.
It’s certainly common to hear it remarked that the bond market is “smarter” than the stock market, which is one of the reasons macro investors often look to the signals that the fixed income world is throwing off.