The yield curve isn’t something that most investors think to look at when it comes to making investment decisions but what it tells you about interest rates can be invaluable. The change that occurs over time between short-term debt securities and long-term debt securities can tell investors what direction the economy is heading in and what interest rate changes may lie ahead.
We’ll briefly review what the three types of yield curves are and what they mean before diving into more details about flat curves and trade opportunities.
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The Normal Yield Curve
A yield curve plots the interest rates of otherwise similar debt securities with differing maturity dates. In a normal yield curve, the most common one, the slope of the curve trends upwards and indicates positive economic growth.
An upward sloping yield curve means that the yields on longer-term debt obligations are higher than those with shorter duration maturities. This happens because risk increases over time, and therefore a longer time horizon means being exposed to more risks. In order to compensate investors for the additional risks involved, a higher yield is offered.
An example of a positive sloping yield curve would be seen if a 1-year AAA bond offered 1 percent, a 5-year AAA bond offered 1.5 percent, and a 20-year AAA bond offered 2.5 percent. The yield increases as the maturity date is pushed further out.
The Inverted Yield Curve
In an inverted yield curve, the slope trends downward and generally indicates an economic contraction or recession. The behavior of this type of inversion is almost the complete opposite of what it is for a normal yield slope.
Unlike the standard upward yield curve with investors expecting a larger yield to compensate for higher risks, the inverted curve tells investors the reverse. In a recession, investors generally expect yields on longer maturity bonds and other debt obligations to drop lower to reflect the poorer economic outlook. Instead, these investors purchase shorter-term maturity debt securities to realize quick returns with yields that are often higher than the long-term ones.
One of the things to keep in mind is that yields are inversely correlated with prices. In other words, when bond yields fall, bond prices rise, and vice versa. Rather than investing for long-term income, these markets are likely to see more speculation than usual with many traders looking for price parities to take advantage of.
The key takeaway for investors is to understand that inverted or downward sloping yield curves are a strong indicator of an upcoming economic recession.
The Flat Yield Curve
In a flat yield curve, the slope is generally trending sideways with yield offerings relatively similar across the board regardless of the maturity date. Investors may see yields on 2-year bonds at 3.00 percent, yields on 10-year bonds at 2.95 percent, and yields on 30-year bonds at 3.05 percent. When this happens, the yield curve is officially called “flat.”
The reasoning behind flat yield curves is varied – it may be a harbinger of a positive or negative economic outlook. The most common appearance of this type of curve is towards the latter end of a long economic boom when market fears regarding a slowdown are building and concerns are raised over the possibility of an interest rate hike.
Market uncertainty is the biggest driver of the flat yield curve. Volatility jumps as investors try to ascertain what the long-term direction of the market will be and trading jitters impact asset prices. While the most obvious cause may be from a changing economic climate, other risk factors such as geopolitical tensions, foreign currency exchange rates, disruptive new technologies, and many more can destabilize markets enough to create flat curves.
In domestic markets, temporary flat yield curves can happen during election years if both candidates are seen as equally likely to win. Unexpected mega-mergers or bankruptcies can also affect investors’ outlook on the market.
In all, the biggest thing to look out for when flat yield curves appear is the uncertainty in the markets. Understanding what risks are impacting the market and how they may change over time is how investors can weather volatile trading conditions and remain profitable.
Trading When the Yield Curve Is Flat
As with any type of yield curve, there are smart and poor investment choices when the resulting curve is flat. For investors, the first critical piece of information you’ll want to know is what stage the economy is at and what the forecast is going forward. If you’ve seen a long growth period or recession and suddenly come across a flat yield curve, chances are it will be directly related to that changing economic climate.
Regardless of the reason, market uncertainty is generally going to be well-above average with volatile trading occurring on a near-daily basis. This kind of activity can generate plenty of opportunities for value investors who are able to identify strong, high intrinsic value companies.
Investors who are able to spot the difference between a company whose value is dropping for justifiable reasons and those whose intrinsic value is still solid in the long term will be the most profitable. For instance, if a flat yield is seen following a rise in geopolitical tensions in the Middle East, a company that sells cookies in the United States and Canada is unlikely to have any connection to that event. Any volatility in that company’s price is probably due to increased market fears and not because the cookie company suddenly sees a huge change in their normal operations.
The Bottom Line
Understanding how interest rates on both short-term and long-term debt securities are changing over time can tell you a lot about the direction of the economy and what market sectors are likely to outperform or underperform. Whether interest rates are high or low isn’t as important of a consideration as how the short-term and long-term debt security yields are behaving relative to each other. Remember, when curves are flat, it generally indicates uncertainty in the markets – a prime opportunity for savvy investors to make smart trades that could deliver long-term, outsized gains.
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