What is a Yield Curve?
Interest rates are constantly changing, and those changes are not linear. Factors that impact short term interest rates are often different than those that affect long term rates and therefore usually move independent of each other. In the US, the most common interest rates used as a benchmark for the marketplace are the rates available on US Treasury Securities. Because of the safety of treasury instruments, these rates are called risk free rates. The US issues treasuries with maturities as short as 1 month and as long as 30 years. When the interest rates on the various term treasuries are graphed, we get a picture, or a graphic representation of what interest rates are. This visualization is called a Yield Curve.
Normal Yield Curve: In a normal yield curve environment, we would traditionally expect the yields on treasuries with a longer time to maturity to be higher than those with earlier maturity dates. Traditionally speaking, the longer you invest your money the greater rate of return you should expect. The yield curve illustrated below has a positive slope to it and is what we expect to see in a normal interest rate environment.
Flat Yield Curve: In certain economic conditions, we can, (and have) experienced a flat yield curve. In these conditions, investors are not rewarded significantly for tying up their money with longer term investments. Although these conditions occur from time to time, they are not typical. Investors should be wary of investing in long term maturity bonds in this environment as they are not being compensated with higher returns for investing their money for longer periods of time.
Inverted Yield Curve : As the picture below illustrates, in an inverted yield curve, short term rates are actually HIGHER than long term rates. This is certainly illogical. Investors are actually penalized with lower rates of return the longer they invest or tie up their money. This situation is extremely uncommon and has only occurred seven times in US history.
The chart below illustrates a number of the points mentioned above. The orange line shows the yields on US Treasury Securities ranging from 1 month (1M) to 30 years (30Y) as of 4/28/2019. At that time the yield curve was normal – short term interest rates were lower than long term rates. The pink line shows the yields on securities with the same maturity but one year later. As you can see, some long term rates have actually dropped below short term rates and the yield curve is now flattened. In fact, not only has the curve flattened, but for securities with maturities from 6 months to 10 years, the curve is inverted – the 3 year security is returning less than the 6 month security!
Investing During an Inverted Yield Curve
Whenever an inverted yield curve occurs and short term interest rates are as high or higher than longer term interest rates, it doesn’t make sense to invest in long term maturities. Relatively speaking, with short term investments offering as much yield as longer term investments, why tie up your money for the same or smaller returns? In short, investors may want to avoid tying up their money for a long period of time. Instead, they could enjoy good liquidity and possibly earn the same (or better) yields with short term investments as they would if they invested long term.
Types of Short Term Investments to Consider
- Money market funds – A mutual fund which invests in short term investments. It offers the investor liquidity, as investors can sell and receive their funds within a day. The portfolio manager invests in liquid, short term vehicles and strives to maintain a stable value of $1/share, while investing and earning income for their investors. It is worth noting that although these funds are offered by brokerage firms, mutual fund companies and banks, these investments are NOT guaranteed or insured like a bank deposit would be.
- Treasury Bills – The US Treasury Department offers a variety of short term T’Bills on a regular basis. Weekly, the treasury offers investors T’Bills with maturities of one month, three months, six months and one year. In an inverted environment, the shortest maturities would offer investors the highest yield. These investments are backed by the full faith and credit of the US government. Although they can be purchased thru a broker, T’Bills are also offered to investors directly by the Treasury department, not requiring the investor to pay any brokerage fees or commission. To learn more about this opportunity, and see the schedule of upcoming offerings, check out: treasurydirect.gov.
- Certificates of Deposit, (CD’s) – Banks issue savings certificates to investors as a way of borrowing money. These instruments are offered in a variety of maturities usually ranging from one month out to 5 years. Again, in an inverted yield curve, the shorter maturities would actually offer the highest yield. When looking to invest in CDs it is important to check with different banks, as the yields offered can range dramatically from bank to bank. Another benefit of this investment is that CDs are insured by the Federal Deposit Insurance Company ( FDIC ) for up to $250,000 per individual / per bank.
Economic Forecasting and the Yield Curve
Many economist and market professionals (this author included), feel that the yield curve is a very accurate forecasting tool to determine where the economy is heading. A normal or positive yield curve is one indicator of a strong economy. Accompanying a strong economy, we traditionally experience higher interest rates and a certain amount of inflation. In that type of environment, as investors tie up their money for longer periods of time, they want a higher return to compensate them.
Alternatively, many professionals consider an inverted curve to be a harbinger of an economic slowdown and likely a recession. In the 200+ year history of the United States securities market, there have been seven recessions that started within a year of the yield curve inverting. It is also important to note that the US has experienced three yield curve inversions where a recession did not occur but there was a marked slowdown in the economy. That being the case, the inverted yield curve appears to be an indicator worthy of being watched, especially if other indicators and economic factors are also showing signs of a market correction.