It ’ s Your Money
Fixed Income ( Part 2 ) — The Yield Curve
5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
By Mark J . Funt DMD , MBA
Above is a fairly normal yield curve . A normal yield curve is generally a straight line with a positive slope . For example , if you drew a line connecting the 3 month point to the 360 month point , that would give you a classical looking yield curve . What makes this yield curve or any designated yield curve “ normal ” is that as you go further out in maturity dates , the yield of the bond goes up . The further you go out in maturity , the more risk you are taking as an investor , and you want to get paid for that risk . I bet there are a lot of people who bought General Motors bonds 5 or 10 years ago who never thought the company would come very close to going bankrupt and their bonds would be
Interest Rate
worth nothing or next to nothing in today ’ s market . The slope of the yield curve can increase or decrease , and in some cases it can flatten or even invert where you would have a zero or even negative slope . One of the things you need to know is where the yield curve was in the past . That ’ s “ where did we come from .” In this particular case , the present yield curve evolved from an inverted yield curve . An inverted yield curve means that shorter maturities yield higher interest rates than longer maturities . You will make more money by investing in shorter term bonds than you would invest in longer term bonds . This is a total contradiction from what it should be . As long term interest rates start to approach short term interest rates ( flattening of the yield curve ) or even become less ( inversion of the yield curve ) than short term rates , the bond market is predicting a slowdown in the economy and an eventual lowering of short term rates by the federal reserve . Although an inverted yield curve doesn ’ t always predict a recession , there has never been a recession that has not been preceded by an inverted yield curve . When the bond market begins to believe the economy is starting or will start to recover , it will start to bid up longer term interest rates in anticipation of and before the Federal Reserve will start to increase interest rates . Remember , both the bond and the stock markets are predictors of what will happen six to nine months in the future . So , the bond market is predicting that we are coming out of a recession and moving into an economic recovery . If only it was that easy ! Unfortunately , the bond ( stock ) markets are not always good predictors and it is always possible that the economy could dip into what is called a double dip recession and the yield curve could once again flatten or invert .
At the time I am writing this article , today ’ s yield curve tells you that if you wanted to buy a three-month treasury bill , you will be paid a whopping 0.19 percent . If you want to buy a one-year treasury bill , you would be paid 0.41 percent and a 10-year treasury bond would pay you approximately 3.7 percent a year for the next 10 years . Today ’ s “ normal ” yield curve is predicting a stronger economy in the future , which is often but not always accompanied by inflation . If the Federal Reserve , after studying
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November / December 2010 • Pennsylvania Dental Journal
49