by Kevin Slater, Lead Advisor, CEO, CFP
Traditionally, at the start of the new school year, we review important concepts from the prior year that will be fundamental in continuing our educational journey. Welcome to your fall class! Since “the yield curve” is featured in articles past (here, and here) and present (here), let’s review what the yield curve is and what it can tell us.
What is the “yield curve”?
Fixed income portions of a portfolio are often primarily made up of bonds- lending instruments that enable corporate and government entities to raise money to fund operations or other projects. US Treasury obligations are considered among the most secure, liquid assets available, with nearly $900 billion bought and sold every day (per SIFMA). Treasury Bills, Notes, and Bonds are issued and sold with a variety of maturity dates: short-term: 1 month to 1 year (e.g., Treasury Bills); medium-term: 2 years to 10 years (e.g., Treasury Notes); and long-term: 20 or 30 years (e.g., Treasury Bonds).
The fixed-income markets determine what the “appropriate” interest rate for the various maturities should be. This is based on many factors, including Treasury supply and demand for fixed income, economic expectations, US Federal budget deficit levels, and Federal Reserve policy expectations.
The yield curve itself is a simple graph that plots what the market implies is the appropriate current interest rate (or yield) for each maturity. Connecting the dots usually creates a sort of curve.
Three Lessons in the Yield Curve
First, it provides an up-to-the-minute market-based valuation for Treasury securities. This helps investors make portfolio-level decisions.
Second, the yield curve is a useful summary of the overall market’s expectations of the economy and interest rates. Higher future rates suggest growth and a stronger economy. Lower future rates suggest economic weakening or a recession.
Finally, while it gives hints on how the general market feels about the economy, it is not a reliable predictor of what will happen in the future.
Why does it matter?
The yield curve is one source we use when projecting returns from various portions of our bond portfolio. It is also a tool for evaluating returns from other types of investments. Does additional risk result in additional reward? Ultimately, it helps us guide clients on the asset mix needed to achieve their goals.