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 Charting
the Yield Curve
When
the Federal Reserve began raising interest rates in June 2004 — the first
increase in four years — the Treasury yield curve started getting lots of
attention. Observers were curious to see how the Fed's policy would play out for
the economy and Wall Street.
The
yield curve captures movements in interest rates and is a key indicator for many
important aspects of the financial world. But it's not just the province of
economists and bond traders — anyone with a basic understanding of the
yield curve can learn important clues about the possible direction of the
economy and the financial markets.
 Riding
the Line
The Treasury yield curve shows the relationship between Treasury bonds of
different maturities. The line shows shorter maturities on the left and longer
maturities on the right. For example, a quick glance at the yield curve will
show the difference between the interest rates on a two-year note and a 10-year
bond.
Economists
look for three basic shapes when plotting the current Treasury yields.¹
An upward
slope, also called a normal yield curve, occurs when short-term debt
instruments are paying lower yields than long-term debt instruments. This occurs
because, under normal circumstances, short-term investments are typically less
risky to the
lender than long-term investments. An upward slope
is common at the beginning of an economic expansion.
A downward
slope, or inverted yield curve, occurs when lenders are concerned that
long-term rates will decline, and they wish to lock in their money before rates
fall further. This occurs when there is widespread belief that economic
activity, and thus the demand for money, is slowing dramatically.
A flat
curve occurs when long-term yields are about the same as short-term
yields. This rare condition occurs when lenders are indifferent to the length of
time they tie up their money because rates aren't expected to change much. This
is symptomatic of a belief that the economy is slowing slightly and is under
little inflationary pressure.
The
Treasury yield curve is one of many important economic indicators. Understanding
the forces that influence the yield curve is critical before making any
adjustments to your long-term financial strategy.
1) Treasurys are backed by the full faith and credit of the U.S.
government as to the timely payment of principal and interest. The principal
value will fluctuate with changes in market conditions. If not held to maturity,
Treasurys may be worth more or less than their original value.
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