If you follow the financial media, you’ll often hear the terms “flattening yield curve” and “steepening yield curve.” But what do these terms mean, and what do changes in the yield curve indicate for investors?
The Yield Curve: A Review
The “yield curve” is simply the yield of each bond along the maturity spectrum plotted on a graph, as shown here. The yield curve typically slopes upward, since investors need to be compensated with higher yields for assuming the added risk of investing in longer-term bonds.(Keep in mind, Rising bond yields reflect falling prices, and vice versa). The direction of the yield curve is typically measured by comparing the yields on the two- and 10-year issues, although the difference the federal funds rate and the 10-year note can also be used.
What is a Flattening Yield Curve?
The term “flattening yield curve” sounds very technical, but in fact the concept is very straightforward. When the yield curve flattens, it means that the gap between the yields on short-term bonds and long-term bonds decreases, making the curve appear less steep. The narrowing of the gap indicates that yields on long-term U.S. Treasury bonds are falling faster than yields on short-term Treasury bonds or, occasionally, that short-term bond yields are rising even as longer-term yields are falling.
Example: On January 2 the two-year note is at 2.00% and the 10-year at 3.00%. On February 1, the two-year note yields 2.10% while the 10-year yields 3.05%. The difference went from one percentage point to 0.95 percentage points, leading to a flatter yield curve.
Why Does a Yield Curve Flatten?
A flattening yield curve can indicate that expectations for future inflation are falling. (Since inflation reduces the future value of an investment, investors demand higher long-term rates to make up for the lost value. When inflation is less of a concern, this premium shrinks.) A flattening also can occur in anticipation of slower economic growth. And sometimes, the curve flattens when short-term rates rise on the expectation that the Federal Reserve will raise interest rates.
What is an Inverted Yield Curve?
On the rare occasions when a yield curve flattens to the point that short-term rates are higher than long-term rates, the curve is said to be “inverted.” Typically, an inverted curve has preceded a period of recession. The reason for this is that investors will tolerate low rates now if they believe rates are going to fall even lower later on. Inverted yield curves a very unusual, having occurred on only eight occasions since 1958. More than two-thirds of the time, the economy has slipped into a recession within two years after the onset of an inverted yield curve.
What is a Steepening Yield Curve?
When the yield curve steepens, the gap between the yields on short-term bonds and long-term bonds increases, making the curve appear "steeper". The increase in this gap indicates that yields on long-term bonds are rising faster than yields on short-term bonds or, occasionally, that short-term bond yields are falling even as longer-term yields are rising.
Example: On January 2 the two-year note is at 2.00% and the 10-year at 3.00%. On February 1, the two-year note yields 2.10% while the 10-year yields 3.20%. The difference went from one percentage point to 1.10 percentage points, leading to a steeper yield curve.
Why does a Yield Curve Steepen?
A steepening yield curve typically indicates investor expectations for 1) rising inflation 2) stronger economic growth (since improving growth causes the demand for longer-term capital to increase even as the Fed maintains a low-rate policy).
Can an Investor Take Advantage of the Changing Shape of the Yield Curve?
For most bond investors, it pays to maintain a steady, long-term approach based on their specific objectives rather than technical matters such as the shifting yield curve. However, traders do have a way to play this trend through two exchange-traded products: the iPath US Treasury Flattener ETN (FLAT) and the iPath US Treasury Steepener ETN (STPP). Both are small and have relatively little trading volume, but they nonetheless provide traders with a way to express an opinion regarding the difference between the performance of short- and long-term bonds.