interest rates going up and going down as if all rates moved together.
The truth is, the rates on bonds of different maturities behave
quite independently of each other with short-term rates and long-term
rates often moving in opposite directions simultaneously. What's
important is the overall pattern of interest-rate movement -- and
what it says about the future of the economy and Wall Street. Rates
are like tea leaves, only much more reliable if you know how to
read them. |
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The is what economists use to capture the
overall movement of interest rates (which are known as "yields"
in Wall Street parlance). Plot today's yields for various maturities
of U.S. Treasury bills and bonds on a graph and you've got today's
curve. |
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Normal and Not Normal |
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Ordinarily, short-term bonds carry lower yields to reflect the
fact that an investor's money is under less risk. The longer you
tie up your cash, the theory goes, the more you should be rewarded
for the risk you are taking. (After all, who knows what's going
to happen over three decades that may affect the value of a 30-year
bond.) A normal yield curve, therefore, slopes gently upward as
maturities lengthen and yields rise. From time to time, however,
the curve twists itself into a few recognizable shapes, each of
which signals a crucial, but different, turning point in the economy.
When those shapes appear, it's often time to alter your assumptions
about economic growth. |
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To help you learn to predict economic activity by using the yield
curve, we've isolated four of these shapes -- normal, steep, inverted
and flat (or humped) -- so that we can demonstrate what each shape
says about economic growth and stock market performance. Simply
scroll down to learn about the significance of that particular
shape. |
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Normal Curve |
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When bond investors expect the economy to hum along at normal
rates of growth without significant changes in inflation rates
or available capital, the yield curve slopes gently upward. In
the absence of economic disruptions, investors who risk their
money for longer periods expect to get a bigger reward -- in the
form of higher interest -- than those who risk their money for
shorter time periods. Thus, as maturities lengthen, interest rates
get progressively higher and the curve goes up. |
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December, 1984, marked the middle of the longest postwar expansion.
As the GDP chart above shows, growth rates were in a steady quarterly
range of 2% to 5%. The Russell 3000 (the broadest market index),
meanwhile, posted strong gains for the next two years. This kind
of curve is most closely associated with the middle, salad days
of an economic and stock market expansion. When the curve is normal,
economists and traders rest much easier. |
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Steep Curve |
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Typically the yield on 30-year Treasury bonds is three percentage
points above the yield on three-month Treasury bills. When it
gets wider than that -- and the slope of the yield curve increases
sharply -- long-term bond holders are sending a message that they
think the economy will improve quickly in the future. |
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This shape is typical at the beginning of an economic expansion,
just after the end of a recession. At that point, economic stagnation
will have depressed short-term interest rates, but once the demand
for capital (and the fear of inflation) is reestablished by growing
economic activity, rates begin to rise. |
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Long-term investors fear being locked into low rates, so they
demand greater compensation much more quickly than short-term
lenders who face less risk. Short-termers can trade out of their
T-bills in a matter of months, giving them the flexibility to
buy higher-yielding securities should the opportunity arise. |
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In April, 1992, the spread between short- and long-term rates
was five percentage points, indicating that bond investors were
anticipating a strong economy in the future and had bid up long-term
rates. They were right. As the GDP chart above shows, the economy
was expanding at 3% a year by 1993. By October 1994, short-term
interest rates (which slumped to 20-year lows right after the
1991 recession) had jumped two percentage points, flattening the
curve into a more normal shape. |
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Equity investors who saw the steep
curve in April 1992 and bet on expansion were richly rewarded.
The broad Russell 3000 index (right) gained 20% over the next
two years. |
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Inverted Curve |
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At first glance an inverted yield curve seems like a paradox.
Why would long-term investors settle for lower yields while short-term
investors take so much less risk? |
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The answer is that long-term investors will settle for lower
yields now if they think rates -- and the economy -- are going
even lower in the future. They're betting that this is their last
chance to lock in rates before the bottom falls out. |
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Our example comes from August 1981.
Earlier that year, Federal Reserve Chairman Paul Volker had begun
to lower the federal funds rate to forestall a slowing economy.
Recession fears convinced bond traders that this was their last
chance to lock in 10% yields for the next few years. |
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As is usually the case, the collective market instinct was right.
Check out the GDP chart above; it aptly demonstrates just how
bad things got. Interest rates fell dramatically for the next
five years as the economy tanked. Thirty year bond yields went
from 14% to 7% while short-term rates, starting much higher at
15% fell to 5% or 6%. As for equities, the next year was brutal
(see chart below). Long-term investors who bought at 10% definitely
had the last laugh. |
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Inverted yield curves are rare. Never
ignore them. They are always followed by economic slowdown --
or outright recession -- as well as lower interest rates across
the board. |
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Flat or Humped Curve |
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To become inverted, the yield curve must pass through a period
where long-term yields are the same as short-term rates. When
that happens the shape will appear to be flat or, more commonly,
a little raised in the middle. |
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Unfortunately, not all flat or humped curves turn into fully
inverted curves. Otherwise we'd all get rich plunking our savings
down on 30-year bonds the second we saw their yields start falling
toward short-term levels. |
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On the other hand, you shouldn't discount
a flat or humped curve just because it doesn't guarantee a coming
recession. The odds are still pretty good that economic slowdown
and lower interest rates will follow a period of flattening yields. |
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That's what happened in 1989. Thirty-year bond yields were less
than three-year yields for about five months. The curve then straightened
out and began to look more normal at the beginning of 1990. False
alarm? Not at all. A glance at the GDP chart above shows that
the economy sagged in June and fell into recession in 1991. |
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As this chart of the Russell 3000 shows,
the stock market also took a dive in mid-'89 and plummeted in
early 1991. Short- and medium-term rates were four percentage
points lower by the end of 1992. |
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