Why Are Different Yield Curves Saying Such Different Things?

(Bloomberg) -- If you're wondering what a yield curve is and why there's so much fretting about it, you're not alone -- there's always a big fuss when it changes shape in an ominous way. The subject is complicated further by the fact that there is more than one curve, and that different curves can sometimes tell different stories.

1. What's a yield curve?

It's a way to show the difference in the compensation investors are getting for choosing to buy shorter- versus longer-term debt. Most of the time, they demand more for locking away their money for longer periods, with the greater uncertainty that brings. So yield curves usually slope upward.

2. How many are there? 

You can calculate a curve between any two bonds issued for a different length of time, or tenor. The U.S. Treasury, for instance, issues three-month bills and 30-year bonds, with others in between. Investors also look at the spreads between the rates at which bonds are trading and the predictions embedded in futures contracts on similar bonds. The futures rate is the sum of the expected short-term rate that far in the future plus a term premium, the extra money investors demand for lending for longer.

3. What changes in shape matter most?

The most alarming developments are flat or inverted yield curves. A yield curve goes flat when the premium, or spread, for longer-term bonds drops to zero -- when, for example, the rate on 30-year bonds is no different than the rate on two-year notes. If the spread turns negative, the curve is considered inverted. (And when spreads increase, the market jargon for that is “steepening.”)

4. Why does it matter?

The yield curve has historically reflected the market's sense of the economy, particularly about inflation. Investors who think inflation will increase typically demand higher yields to offset its effect. Because inflation usually comes from strong economic growth, a sharply upward-sloping yield curve generally means that investors have rosy expectations. An inverted yield curve, by contrast, has been a reliable indicator of impending economic slumps, like the one that started in 2007. In particular, the spread between three-month bills and 10-year Treasuries has inverted before each of the past seven U.S. recessions.

5.  Which curve matters most? 

It depends who you ask -- and it's an important question as different curves can be sending out conflicting signals. The two-year, 10-year U.S. curve is perhaps the most popular; in late March, it was close to inverting. But a 2018 paper by the U.S. Federal Reserve Bank of San Francisco found the difference between 10-year and three-month Treasury rates is the most useful forecaster, and in March that curve was at its steepest since 2017. Another 2018 Fed paper recently cited by Fed Chair Jerome Powell hailed the so-called “near-term forward spread”, or the difference between the 18-month (six-quarters-ahead) forward rate and the three-month yield. As of late March, that was also the steepest it had been in decades. 

6. What do the differences between curves mean? 

That can be hard to say. Divergences can reflect the way different tenors capture different stages of the Fed's monetary policy cycle. In March, for instance, the Fed was expected to be hiking swiftly later in the spring but not in two years' time. The shorter-term yield curve also eliminates complicating factors like term premium. Of course, it's worth remembering that all yield curves reflect market speculation, and one could legitimately question the ability of financial markets to predict much accurately beyond a 12 month horizon. 

The Reference Shelf

• Bloomberg Opinion columnist John Authers wrote about the differences between yield curves and their meaning.
• A Federal Reserve Bank of San Francisco paper on the squeeze on the yield curve.
• Frequently asked questions on the yield curve from the Federal Reserve Bank of New York.
• A Federal Reserve Bank of Richmond paper wonders whether yield curves may now invert for reasons other than recession risks.
• A QuickTake on bull and bear, flattening and steepening yield curves.

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