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Yield Curves Explained

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KATHY JONES: Recently, there’s been a lot of talk about the yield curve. Investors in both bonds and stocks have been concerned that the yield curve might invert, and that’s usually not a good signal for the economy or for the markets. But not everybody is familiar with this concept or what it means for their investments. I’m Kathy Jones and this is Bond Market Today.

Let me start by defining what we mean by the yield curve. Essentially, it’s a summary of yields across a spectrum of maturities in the bond market, from very short-term to very long-term. Normally, the yield curve slopes upward, short-term rates are lower than long-term interest rates, because if you’re going to tie up your money for a longer period of time, usually as an investor, you’re going to want more compensation for the risk that you’re taking, so those yields tend to be higher.

Now, it isn’t always the case that the yield curve is sloping upwards. There are times when inflation expectations might be falling and long-term rates may come down relative to short-term rates and vice versa. Historically, the yield curve has flattened when the Federal Reserve has been raising short-term interest rates because tightening monetary policy usually signals slower growth and lower inflation across the board.

Now, every once in a while the yield curve will invert. Short-term rates will actually move above long-term rates, and that’s what we refer to as an inverted yield curve. And the reason is typically that the Fed has been very aggressive in raising short-term interest rates, and that has caused inflation expectations to fall. And when that happens, it can also be a signal of a recession coming in the next year or so.

Now, one of the reasons behind that is that the difference between short- and long-term rates is a proxy for bank lending profitability. Banks tend to borrow at short-term rates and lend at longer-term rates, and so they earn that yield spread. And when the yield curve inverts or collapses, then it’s less profitable for banks to lend, and that tends to slow down economic activity because consumers aren’t able, perhaps, to get mortgages to buy houses or auto loans, and businesses aren’t able to get loans to expand their business, and it can lead to a recession, which is why investors get very concerned about the slope of the yield curve and what it’s signaling about the economy.

If you would like to learn more about the bond market, please visit Schwab.com and go to the Insights and Ideas tab, or follow me on Twitter @KathyJones. Thanks for watching.

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