Understanding The Yield Curve – How To Invest In Stocks

The yield curve is an important indicator for the economy especially if you are just learning how to invest in stocks.  But, oftentimes, “reading” the yield curve is a difficult task. I have put together the Yield Curve “movie” where I show a visual explanation of the yield curve.  Watching the yield curve as it ebbs and flows will give you an understanding of what my happen next in the financial market.

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The Current Yield Curve

Current Yield Curve

Right now, the yield curve is showing us that there are expectations for interest rates to ease off from the current levels.

What is the Yield Curve?

The first thing to understand is: What is the yield curve.  It is a visual representation of yields  on the same quality of debt instruments over many different maturity dates.  The United States Treasury reports its daily yields for the various maturities.  The information in these charts are from the Treasury Yield data.

Yield Curve Bar Chart & How to Invest In The Stock Market
The Yield Curve in bar chart format from 06/23/2006

In the above chart you can see the maturities for all of the various dates over the course of time.  This is from 06/23/2006.  This is the last “normalized” yield curve the US economy has experienced in many years.

The above chart is in bar format.  During the 1970s, financial professionals realized you could convert this into a line chart.  And, after doing that, the financial professionals found the visual was easy to interpret.

Yield Curve Line Chart
Yield Curve Line Chart: 06/23/2006

The above line chart is the exact same chart at the above bar chart.  From a visual standpoint, examining the yield curve using a line chart allows for easier interpretation.

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The 10-2 Spread

10-2 Spread

There is an often viewed spread differential between the 10-year yield and the 2-year yield for the yield curve.  Normally, this spread is positive.  But, at times the spread will be negative.  This is because the market believes that the Federal Reserve will have to lower interest rates in the future.  This negative spread will show up in the 10-2 spread.

Given current information about the future economy, if the market expects that the economy will continue to improve over a period of time, interest rates tend to be higher out in the future based upon the idea of unknown risks.

For instance, the current Federal Funds interest rate would be appropriate for any one period of time.  If the Federal Reserve is not expected to increase nor decrease interest rates because of an economy in complete equilibrium, then the only unknown variables over time would be incorporated into the analysis.

What is an inverted Yield Curve?

As mentioned, an inverted yield curve would have interest rates that are lower in more distant maturities versus near-term maturities.

Inverted Yield Curve 08/29/2006 the last normalized yield curve was followed by an inverted yield curve.
Inverted Yield Curve 08/29/2006 – prior to 2008 financial crisis

The above yield curve, just 2 months after the previous normalized yield curve, was a signal of financial change was imminent.  In this case, the inverted yield curve was detailing the housing crisis was looming.

In the case of the 2008 housing crisis, mortgage holders were starting to feel the strains of the balloon mortgage rates.  Because of this, longer-dated interest rates began to fall.  This is owed to the fact that long-term bond issuers were taking on less risk.  As there was less supply, prices rose for what supply existed.  The inverse relationship between price and yield for interest rates drove prices upward and yield on longer end maturities began moving lower.

What does an Inverted Yield Curve Tell Investors?

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If you can glean from the interest rates that bond issuers are not supplying as much debt, and subsequently there is a push upward in price of what debt is being issued, the visual representation of the yield curve will show the longer maturity dates are dropping relative to shorter-dated debt instruments.

An investor would want to understand what is happening in the longer dated maturities and ask the question why debt issuers are not offering more debt; why these debt issuers are taking on less risk.

If, in fact, the yield curve is showing that there is a significant shift in risk appetite, a recession may be looming.  And, investors would need to be cautious in the future.

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