10Y-2Y Spread:


An Introduction to Yield Curves

The "Yield Curve" is a very important concept in the field of economics. Though it may sound complicated, a yield curve is really quite simple: it's nothing more than a visual representation of the interest rates that the U.S. Treasury must pay on its debt.

To fund the U.S. government, the U.S. Treasury must sell bonds (because Congress keeps cutting taxes, the government isn't able to pay for its programs outright, it must borrow money). Think of a bond like a loan: you buy a bond from the government (giving the government a loan) and it makes payments to you periodically for a specified number of months/years. This period of time is referred to as a maturity.

There are short term bonds (the shortest offered by the U.S. Treasury matures after only one month) and many more longer term bonds. Generally speaking, bonds that have longer maturities need to pay bond holders more interest than short term bonds because investors are tying up their money for a longer time. For a yield curve, short term maturities are placed on the left side of the x-axis, whereas long term maturities are on the right side, therefore yield curves are generally upward sloping.

Think of debt like a commodity, subject to the laws of supply and demand just like anything else.

The interest the U.S. government pays on bonds can be thought of as the "base-rate" for debt globally, because the debt of the United States is considered "risk-free." That is, investors do not consider it a possibility that the U.S. won't pay them back. Across the board, other governments, corporations, or municipalities that issue bonds will end up paying more interest than the U.S. government pays on their debt.

The price paid for a bond and its yield are negatively correlated. This is one of the most important things that you need to know about bonds. When the demand for a particular bond is high, this drives the price of the bond up and the interest rate down. When there is a great deal of demand for liquidity in an economy for purposes of investment, short term bonds will have yields that are much lower than long term bonds. Investors are willing to pay more (the price of the bond is high) for these bonds which drives their yields down.

But what about a yield curve inversion? An inverted yield curve refers to a situation where yields for short term bonds exceed those of long term bonds, which is unusual and seems to contradict the idea that a bond issuer will pay investors more interest for loaning the issuer money for a longer time. How do we explain this? When an economy is nearing the end of the business cycle, investors being to see the writing on the wall and know that an economic downturn is imminent. The recession that's right around the corner incentivizes investors to find a safer place to put their capital: long term bonds. Demand for liquidity begins to plummet as capital is shifted from short term to long term bonds, causing short term yields to increase (as demand wanes and prices drop) and long term yields to decrease (as demand and prices increase). Short term yields can then exceed long term yields, resulting in a yield curve inversion.

Check out the visualization of the Great Recession below to see a yield curve inversion and what happens to the yield curve shortly thereafter.


The most common metric for judging the "slope" of the yield curve is the 10 year-2 year spread, which refers to the difference between the yield on the 10 year Treasury and 2 year Treasury. Using the 10-2 spread, you can see that the yield curve inverts in February, 2006. Many people (perhaps the majority) in the finance and economics community believe that a yield curve inversion is the most accurate predictor of a recession, because this phenomenon has preceded every recession since the 1960's. However, there is a question of how much of a self-fulfilling prophecy this has become, i.e. because investors believe that it indicates a recession is near, they then react in a way that creates the recession. Regardless, the 10-2 spread is extremely important to pay attention to.

What factors affect interest rates?

Copyright 2018 Yield Curve Now! - by Tyler Pedigo

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