One of the more puzzling financial terms to many of us is the “yield curve.” While most people probably don't even know it exists, it does play an important role in our financial lives. The yield curve determines what we pay to borrow money, as well as what we can expect to earn if we invest in interest-bearing assets.
This curve has been getting lots of press lately, primarily because it's been known as an indicator of future economic activity. Let's start with a description. The yield curve is comprised of interest rates for various government bonds, as well as low-risk corporate bonds, with maturity dates ranging from 30 days to 30 years.
But how does it affect us? To begin with, the shape of the curve gives us some insight into what investors think about the economy.
In general, interest rates increase as we move from short-term to long-term bonds. In other words, investors expect to be paid a premium, i.e., a higher interest rate, in exchange for tying their money up for a longer period of time. We can think of this premium as a kind of insurance against the risks of unforeseen changes in the economy and inflation.
Under certain conditions, however, interest rates actually decrease as the term of the bond increases. When this happens, we have what's called an “inverted” yield curve — and it usually means we can expect a recession within a year of the time the shape changed. This inversion tends to happen when investors think that interest rates are going to decline sharply, signaling a recession.
Does this mean there's one in store for us right now?
Well, there's another side to the story — naturally. Under the second scenario, bond yields are based on supply and demand. If the U.S. Treasury decides to retire the national debt by buying back, or not issuing, 30-year bonds, then demand will outstrip supply. When this happens, the bond price will go up and the bond yield will go down.
Through a kind of domino effect, the demand for medium-term bonds could also increase. Why? There won't be enough 30-year bonds to meet demand, so investors who want to keep their money in the less-risky government sector will buy medium-term bonds to lock in the relatively long-term yield. This rise in demand will force yields paid by medium-term bonds to decrease.
I don't remember this confluence of events taking place at any time during the past 20 years. But it's happening now. As a result, we're getting a false indicator of a recession from what's usually a reliable statistic — the yield curve.
Those of us who may need to borrow money in the not-so-distant future (to pay for a child's college education, for example) need to get a handle on which scenario is more accurate. We need to figure out whether we want our loans based upon prime-plus, or whether we should take out a second mortgage based on long-term bond movements.
If the Treasury keeps cutting back on the number of long-term bonds it issues, we can assume that long-term bond yields will decline as demand outstrips supply. This will be good news for the corporations issuing medium- to long-term bonds to borrow money, but bad news for people who want to invest their money in the safer havens of government securities.
If you're planning for retirement, it really might not be in your best interest for the Treasury to pay down all of the federal debt.