- The yield curve shows the relationship between bond yields and the maturity length of different bonds
- An inverted yield curve exists when the yield on a short-term bond is higher than that of a bond with a longer term
- Inverted yield curves have been accurate predictors of recessions, but they are lagging indicators
- Both growth and income investors can find strategies to profit from an inverted yield curve
One of the more significant talking points among market analysts in 2022 is the yield curve's status. The yield curve is a visual representation of the relationship between bond yields and the maturity length of different bonds. The two most often referenced bonds in terms of the yield curve are the United States 2-Year and 10-Year treasury bonds.
The significance of the yield curve has to do with the value of a dollar today versus the value of that same dollar at a point in the future. Investors would expect to receive a higher yield for holding a bond for ten years than they would when holding a bond for two years. This is considered a normal yield curve.
An inverted yield curve happens when the yield of a shorter-term bond climbs higher than that of a longer-term bond. This is important for an investor who relies on a fixed income. And even though the standard 60/40 portfolio is no longer a sure-fire template for investing success, chances are many investors have some exposure to bonds.
This article will look at the relationship between interest rates and some trading strategies using the yield curve.
What Causes a Yield Curve to Invert?
The yield curve is tied to interest rates. Specifically, as interest rates rise, bond yields fall. The opposite is also true; when interest rates decline, bond yields rise.
The yield curve is a visual representation of this relationship. When the inverted curve starts to flatten, particularly when it becomes inverted, it suggests the economy is slowing. However, understanding how this should inform your investing strategy requires understanding what rising interest rates mean to the economy. And for that, you must look at the banks.
When the economy is expanding, banks use short-term borrowing (from depositors or bank-to-bank lending) to fund the loans they make (business, home loans, etc.). When long-term interest rates are higher than short-term rates, it is seen as a sign that lending is profitable. It also implies that access to credit is plentiful.
The opposite is also correct when credit markets tighten, banks become less likely to lend, which is typically when long-term rates go down, and the yield curve starts to flatten. This is one reason why investors see a flattening or inverted curve as a signal that the economy is entering a recession. In fact, before every recession since World War II, the yield curve has inverted.
The Yield Curve is a Lagging Indicator
One concern about the yield curve is that it is a snapshot of events that have already taken place in the market. One of the most obvious examples of an event that can affect bond yields is when the Federal Reserve changes the federal funds rate.
These moves, however, are usually telegraphed – and some might even say choreographed so that the markets have largely absorbed the effect of the interest rate adjustment before they happen.
But this is where investors can profit by trading the yield curve. Traders can use the yield curve to discover what length of bonds to invest in. Also, bonds and stocks tend to move in opposite directions so when long-term bond yields are declining, it may be a good opportunity for investors to look at stocks for a higher rate of return.
Fixed-income investors can look at the spread between different instruments to see if bonds are their best bet. For example, the typical spread between a 91-day U.S. Treasury bill and a 3-month certificate of deposit issued by a bank is about 0.40 percent (typically referred to as 40 basis points).
If an investor sees this spread increase to 0.70 percent, that suggests that a bank CD is a better investment. But if the spread between them narrows to around 0.20 percent, it would make the Treasury bills a better option. This spread will differ depending on the length of the bond being compared.
Another strategy for trading using the yield curve is to “ride the yield curve.” This technique is typically only used with normal (i.e., upward-sloping) yield curves. In this strategy, investors buy a bond with a longer term than they plan to hold it.
They then sell the bond at the date they had initially desired. In this way, they get a higher total investment return because they earn a high-interest rate on the bond at the time they purchase it, plus they get a capital gain when they sell the higher return bond.