It might seem odd to call a flat line a “curve.” But flat is just one shape that the yield curve—a measure of interest rate expectations—takes on. It can also slope upward (positive slope). It can invert (negative slope). We’ll get to all that in a moment.
Bond traders use the yield curve to identify the relative value of a single maturity versus rates on other bond investments. The yield curve helps traders determine if a particular bond will compensate its holder for exposure to changing interest rates or inflation.
For stock investors, the shape of the curve offers hints about how interest rate markets are positioning for current expectations on future rates, inflation, Federal Reserve action, international economic disruptions, and other current expectations on developments that can sway stock values.
First, What Is It?
The yield curve is a graph of Treasury yields across different maturities. Short-term maturities like bills and notes are plotted on the front (left side) of the curve, while long-term maturities or bonds are plotted further out (right side). See figures below.
A bond trader might observe that 30-year yields are higher than 20-year yields. If the difference is large enough, the bond trader might be willing to accept more risk in the longer maturity to capture a higher yield.
Stock Tool, Too
Stock traders might use yield curve observations to help get a rough idea about interest rate and inflation expectations. Again, the yield curve takes three shapes: positive-sloping, negative-sloping, and flat.
A positive-sloping, or “normal,” yield curve is the typical shape shown in figure 1. A normal yield curve forms when bonds with shorter maturities yield less than bonds with longer maturities. This is the usual shape because longer maturities have more exposure to value-eroding inflation or other potentially risky factors. That means investors expect a higher yield to compensate. Importantly for stock investors, the yield curve is usually positive when the economy is growing, and economic growth typically leads to increasing corporate profits and rising stock prices.
A negative-sloping, or inverted, yield curve is shown in figure 2. An inverted yield curve forms when bonds with shorter maturities yield more than bonds with longer maturities. That could happen because of a recession, for example, or if extraordinary demand is flowing into longer-term Treasuries because the U.S. may be deemed the safest place to stash money in the wake of global political or economic rumblings.
An inverted yield curve is a potential warning sign for stock investors because it signals possible slowing corporate profits and a potential fall in stock prices. The last two times the yield curve inverted were 1999 and 2007—right before bear markets in stocks.
A flat yield curve is illustrated in figure 3. The yield curve gets flat when bonds with shorter maturities yield roughly the same as bonds with longer maturities. A flat yield curve is also rare and usually forms when the curve is transitioning from normal to inverted, or inverted to normal.
The yield curve has been positive since the financial crisis that ended in 2009. The slope remains positive today. However, stock investors might do well to pay attention to the yield curve over the next 12 months or so.
Why? There’s a lot of timing uncertainty around the Federal Reserve hiking its fed funds rate, an ultra-short-term rate that influences the broader interest rate spectrum. For instance, some economists worry that a Fed rate hike this year could be premature and tip the economy into a recession.
The yield curve could help investors decide whether or not these worries are justified. After all, long-term yields are already historically low. A small increase in short-term interest rates at the front of the curve courtesy of the Fed could conceivably push the yield curve into a flat or even inverted shape. If this happens, investors may want to take note of the warning signal.