March 25, 2005 — With the Fed tightening the screws on short-term interest rates another notch this week, Answer Desk readers are wondering what impact rising rates will have on the economy. Like a lot of investors, John in Florida is keeping his eye on the bond market’s so-called “yield curve” -- and he’s looking for an explanation of what this widely-watched chart is saying.
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The yield curve: Inverted? Steepening? Please elaborate: Why does a flattening yield curve portend rough going for the economy?
—John R., West Palm Beach, Fla.
Of all the tea leaves used to forecast where the economy is headed, this little squiggle is one of the most closely watched. And while some of the incantations chanted by “yield curve” followers may sound like voodoo, the basics are pretty straightforward.
Simply put, the yield curve is a graph showing the difference in interest rates (or “yield” in bond trader parlance) paid by bonds of short, medium and long maturities. Usually, the curve starts out low on the left (showing lower yields offered by 1-month, 3-month and 6-month Treasury bills) and steadily rises as it tracks the yields for 2-year, 5-year, 10-year notes and 30-year bonds.
This is a “normal” curve -– because investors expect to get paid more to cover the risk of investing in the longer maturities on the right side of the graph. One of those risks, for example, is that by locking in your money for such a long time, you could miss out on higher rates down the road. Another risk is that inflation could pick up again -- and eat away at the buying power of your savings while you’re stuck holding that long-term bond.
The yield curve changes shape over time, based on a number of factors. (Fidelity Investments’ Web site has a nifty “movie” showing how the yield curve has changed over the past 25 years.) On the long end of the curve, strong demand for bonds usually pushes rates lower –- because the government has so many bidders at its quarterly auction of new paper that it can sell it “cheaply” by offering relatively low interest rates. On the other hand, inflation worries can drive rates higher for longer maturity bonds. (When investors fear that rising inflation may erode their savings, they demand higher interest rates to make up for that loss.)
Over on the “short end” of the yield curve, rates are much more sensitive to actions by the Federal Reserve, which has recently been cranking short-term rates higher. Despite those moves, long-term rates have fallen over the past year, so the yield curve has been flattening.
Why the flattening? Most analysts are hard pressed to explain just what’s going on. Fed head Alan Greenspan last month said that the “broadly unanticipated behavior of world bond markets remains a conundrum.” (Translated: “Beats me.”)
Occasionally, short-term rates rise even higher than long-term rates -– a condition known as an “inversion” of the yield curve. Though not common, an inverted yield curve is almost always bad news. Over the past few decades, it’s been one of the most reliable signs that a recession is coming. (The yield curve was last inverted in the summer and fall of 2000 –- just before the recession of 2001.)
There are lots of explanations for why this inversion is bad for the economy. One simple way to look at it is to think of short-term rates as the “wholesale” price of money and long-term rates as the “retail” price. Banks typically borrow at short term rates and use that money to make multi-year loans. The difference -– the “spread” -– is their profit.
So if short-term rates are higher than long-term rates, you can see why banks would be reluctant to keep lending: their profit dries up. And when lending slows, so does the economy, because businesses have a harder time finding the money they need to expand and hire more people.
Despite the recent “flattening” of the curve, there are signs that the “long end” of the market is finally moving higher as well. One big reason: the seeming relentless rise in oil prices has gotten the financial markets worried about inflation.
So keep your eye on that little squiggle. It can tell you a lot about what lies ahead for the economy.
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