The Living Yield Curve
PEOPLE TALK ABOUT interest rates going up and going down as if all rates moved together. The truth is, the rates on bonds of different maturities behave quite independently of each other, with short-term rates and long-term rates often moving in opposite directions simultaneously. What’s important is the overall pattern of interest-rate movement — and what it says about the future of the economy and Wall Street. Rates are like tea leaves, only much more reliable if you know how to read them.
The yield curve is what economists use to capture the overall movement of interest rates (which are known as "yields" in Wall Street parlance). Plot today’s yields for various maturities of U.S. Treasury bills and bonds on a graph and you’ve got today’s curve. As you can see on the adjoining chart, the line begins on the left with the shortest maturity — three-month T-bills — and ends on the right with the longest — 30-year Treasury Bonds.
Normal and Not Normal
Ordinarily, short-term bonds carry lower yields to reflect the fact that an investor’s money is under less risk. The longer you tie up your cash, the theory goes, the more you should be rewarded for the risk you are taking. (After all, who knows what’s going to happen over three decades that may affect the value of a 30-year bond.) A normal yield curve, therefore, slopes gently upward as maturities lengthen and yields rise. From time to time, however, the curve twists itself into a few recognizable shapes, each of which signals a crucial, but different, turning point in the economy. When those shapes appear, it’s often time to alter your assumptions about economic growth.
To help you learn to predict economic activity by using the yield curve, we’ve isolated four of these shapes — normal, steep, inverted and flat (or humped) — so that we can demonstrate what each shape says about economic growth and stock market performance. Simply scroll down to one of the curve illustrations on the left and click on it to learn about the significance of that particular shape. You can also find similar patterns within the past 18 years by running our "yield-curve movie" and — by clicking the appropriate box — you can compare any shape within that time period to both today’s curve and the average curve.
When bond investors expect the economy to hum along at normal rates of growth without significant changes in inflation rates or available capital, the yield curve slopes gently upward. In the absence of economic disruptions, investors who risk their money for longer periods expect to get a bigger reward — in the form of higher interest — than those who risk their money for shorter time periods. Thus, as maturities lengthen, interest rates get progressively higher and the curve goes up.
December 1984, marked the middle of the longest postwar expansion. As the GDP chart above shows, growth rates were in a steady quarterly range of 2% to 5%. The Russell 3000 (the broadest market index), meanwhile, posted strong gains for the next two years. This kind of curve is most closely associated with the middle, salad days of an economic and stock market expansion. When the curve is normal, economists and traders rest much easier.
Typically the yield on 30-year Treasury bonds is three percentage points above the yield on three-month Treasury bills. When it gets wider than that — and the slope of the yield curve increases sharply — long-term bond holders are sending a message that they think the economy will improve quickly in the future.
This shape is typical at the beginning of an economic expansion, just after the end of a recession. At that point, economic stagnation will have depressed short-term interest rates, but once the demand for capital (and the fear of inflation) is reestablished by growing economic activity, rates begin to rise.
Long-term investors fear being locked into low rates, so they demand greater compensation much more quickly than short-term lenders who face less risk. Short-termers can trade out of their T-bills in a matter of months, giving them the flexibility to buy higher-yielding securities should the opportunity arise.
In April 1992, the spread between short- and long-term rates was five percentage points, indicating that bond investors were anticipating a strong economy in the future and had bid up long-term rates. They were right. As the GDP chart above shows, the economy was expanding at 3% a year by 1993. By October 1994, short-term interest rates (which slumped to 20-year lows right after the 1991 recession) had jumped two percentage points, flattening the curve into a more normal shape.
Equity investors who saw the steep curve in April 1992 and bet on expansion were richly rewarded. The broad Russell 3000 index (right) gained 20% over the next two years.
At first glance an inverted yield curve seems like a paradox. Why would long-term investors settle for lower yields while short-term investors take so much less risk?
The answer is that long-term investors will settle for lower yields now if they think rates — and the economy — are going even lower in the future. They’re betting that this is their last chance to lock in rates before the bottom falls out.
Our example comes from August 1981. Earlier that year, Federal Reserve Chairman Paul Volcker had begun to lower the federal funds rate to forestall a slowing economy. Recession fears convinced bond traders that this was their last chance to lock in 10% yields for the next few years.
As is usually the case, the collective market instinct was right. Check out the GDP chart above; it aptly demonstrates just how bad things got in 1981 and 1982. Interest rates fell dramatically for the next five years. Thirty year bond yields went from 14% to 7% while short-term rates, starting much higher at 15% fell to 5% or 6%. As for equities, the next year was brutal (see chart below). Long-term investors who bought at 10% definitely had the last laugh.
Inverted yield curves are rare. Never ignore them. They are always followed by economic slowdown — or outright recession — as well as lower interest rates across the board.
Flat or Humped Curve
To become inverted, the yield curve must pass through a period where long-term yields are the same as short-term rates. When that happens the shape will appear to be flat or, more commonly, a little raised in the middle.
Unfortunately, not all flat or humped curves turn into fully inverted curves. Otherwise we’d all get rich plunking our savings down on 30-year bonds the second we saw their yields start falling toward short-term levels.
On the other hand, you shouldn’t discount a flat or humped curve just because it doesn’t guarantee a coming recession. The odds are still pretty good that economic slowdown and lower interest rates will follow a period of flattening yields.
That’s what happened in 1989. Thirty-year bond yields were less than three-year yields for about five months. The curve then straightened out and began to look more normal at the beginning of 1990. False alarm? Not at all. A glance at the GDP chart above shows that the economy sagged in June and fell into recession in 1991.
As this chart of the Russell 3000 shows, the stock market also took a dive in mid-1990 and plummeted later that year. Short- and medium-term rates were four percentage points lower by the end of 1992.