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Why you should care about the yield curve

Paddy Hirsch Sep 9, 2015
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Think of the yield curve in terms of "Chutes and Ladders"
Ben Husmann/Flickr

Here’s a sunnier economic forecast this Wednesday, brought to you by the yield curve.

As Marketplace Morning Report host David Brancaccio reported, yields on 10-year bonds are rising. Which means that the yield curve is getting steeper, which means that investors are getting more bullish on the economy.

Confused about how the yield curve works? It’s really pretty simple. If you’ve ever played the game “Chutes and Ladders,” you can understand it, as this very short explainer shows:

 

 

This steepening of the yield curve is the opposite of what was happening just a couple of weeks ago. Financial news outlets reported a flattening of the yield curve, as investors speculated about what the Federal Reserve Board might do with interest rates following its meeting next week.

The yield curve is a graphic representation of the relationship between short- and long-term yields.

In other words, it’s a line on a graph showing what kind of return investors are demanding in return for taking both short-term risk and long-term risk. Which they do by investing in short-term and long-term bonds. 

If you’re not going to get your money back for a long time, like 30 years, then you’re taking on more risk than if you’re just lending for, say three months. And in normal circumstances, the reward for taking a long-term risk is greater than that for taking short-term risk. Which means the yield on a longer-term bond will be higher than on a shorter-term bond. 

Which is what we’re seeing today: the 10-year bond yield has risen, steepening the yield curve.

But what if investors think that things may get bumpy in the economy in the next few months? In that case, they might feel they’re taking a bigger risk investing in short-term bonds, and they might therefore demand more compensation in the form of a higher yield. That increase in short-term rates, when you plot it on a graph, will result in a flattening of the curve

A flattening yield curve, then, is a sign that investors think that there may be a transition in the economy. Emphasis on the word think. Just because they think something don’t make it so.

Moreover, investors change their minds all the time, and they buy and sell based on those changes. That buying and selling activity can change the yield curve very quickly. It’s quite possible that you may see the yield curve flatten a bit early next week, ahead of the Federal Reserve meeting. And then it depends what happens on the day. If the Fed decides to raise rates, the curve may flatten even more, as fear pushes investors to demand higher yields for short-term paper. If it decides to hold rates steady for another quarter, the curve might well steepen again, as investors see less risk in short-term rates and yields fall.   

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