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Eyes
on the Yield Curve
They say a
picture is worth a thousand words. Some Wall Street observers would tell you
that a chart or graph can tell a pretty good story, too.
The Treasury
yield curve is a closely watched indicator of interest rates — watched more
closely at some times than others. For example, when the Federal Reserve
reversed the direction of short-term interest rates in June 2004, the yield
curve's reaction drew significant attention. The curve did not react as many
people expected, but instead flattened out as long-term rates stayed low. This
normally rare occurrence provided clues about the possible future direction of
the economy.
The yield curve can be a tremendous source of information for those who know how
to read it.
Reading the T-Leaves
Economists look for the Treasury curve to assume three basic
shapes. An upward slope occurs when bonds of longer maturities are paying higher
yields than bonds of shorter maturities.¹ A flat curve occurs when short- and
long-term yields are about the same. A downward slope occurs when short-term
bonds are paying higher yields.
To understand the meaning of various curve shapes, consider the motivations of
lenders and borrowers under ideal circumstances. Lenders tend to prefer
shorter-maturity investments because they are less volatile and the money will
be more accessible if interest rates begin to rise. Borrowers prefer
longer-maturity loans so they can lock in favorable interest rates.
The upward slope is most common because investors want to earn higher interest
rates to wait longer periods for the return of their principal. When this
occurs, it may signify that a period of economic expansion is ahead or underway.
When a period of economic growth appears to be nearing a peak, the Federal
Reserve may decide to raise short-term rates to help keep economic growth from
overheating. This may cause lenders and borrowers to become less concerned about
future interest rates because inflation is less of a threat, and the yield curve
flattens.
A downward slope occurs when there is widespread belief that economic activity,
and thus the demand for money, is slowing dramatically. Lenders fear falling
long-term rates and wish to lock in their money before rates fall further.
Much can be learned from watching changes in the yield curve, but it would be
foolish to give these changes too much weight. Please call if you would like to
discuss how changes in interest rates may influence your investments.
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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