The Yield Curve

 In the bond market, a yield curve is the indicator that most investors watch more than any other. Few indicators are as reliable as the yield curve, and it’s one of the best forecasting tools available. The yield curve isn’t as good as a crystal ball, but it’s a fairly good way to assess the short-term direction of interest rates.

The yield curve charts the yield on bonds against their maturities. The shape of the yield curve is generally upward-sloping, with yields increasing as maturities lengthen. A normal yield curve is one in which the yields on long-tern maturities are higher than the yields on short-term maturities. A yield curve graph may range from three months to 30 years.

To keep things simple, consider the U.S. Treasury yield curve, which I discuss momentarily. It’s just one of many yield curves, but it’s the most widely used.

Serious investors focus on the shape of the U.S. Treasury yield curve to gauge the U.S. economy. You can look at the U.S. Treasury yield curve in two basic ways:

• If the yield curve is “positively sloped” or steep, it indicates that short-term interest rates are relatively low and will remain low. Fed interest rate reductions put downward pressure on short-term interest rates.
  
• If the curve is “negatively sloped” or inverted, it’s usually seen as a indication that short-term interest rates are relatively high and are expected to remain high, with the Fed engaged in a strategy of slowing the economy by reining in short-term interest rates.

Understanding what shapes the yield curve

The ten biggest factors that affect the yield curve are

• Mnetary policy and future expectations about the Fed
• Economic growth
• Fiscal policy
• Inflation expectations
• The U.S. dollar
• Flight to quality
• Credit quality
• Competition for capital
• Debt buy-backs
• Portfolio shifts

There are good reasons to keep track of the U.S. Treasury yield curve. The good news is that there isn’t a need for sophisticated analysis to forecast from the yield curve — it’s relatively simple and easy.

Treasury Notes are intermediate securities with maturities of one to ten years, whereas U.S. Treasury Bonds are longer-term securities with maturities of ten years or longer. A quick glance at a spread between two-year Treasury Notes and the 30-year U.S. Treasury Bonds is all that you need to draw a conclusion about both the economy and the markets. Also, the simplicity of the yield curve allows you to double-check conclusions drawn from more sophisticated indicators. And the yield curve can serve as a useful gauge of market sentiments.

The expectations theory

This theory is based on the investor’s expectations of future interest rates. According to the expectations theory, when the yield curve is upward-sloping, short-term interest rates will rise. Conversely, an inverted yield curve reflects expectations that future short-term interest rates will fall. A flat yield curve? You guessed it — the expectation is that short-term interest rates will remain constant.

The liquidity preference theory

This theory holds that yields on longer-term maturities are higher than yields on shorter-term maturities, because investors want additional compensation for the increased risks associated with holding longer-term maturities. Investors recognize that maturity and price volatility are directly related. This is why the yield curve is almost always upward-sloping.

The market segmentation theory

This idea is based on the notion that the yield curve shape is determined by asset liability constraints, either regulatory or self imposed. Such restraints confine borrowers and creditors to specific maturity sectors. In other words, supply and demand determine the shape of the yield curve