Tahoe-Truckee Market Beat: What is up with the Yield Curve?
February 24, 2015
The Yield Curve walks into a bar. The bartender says, "Hey, you're really getting into shape!"
The Yield Curve replies, "Yep. I believe the Expectations Hypothesis is working on my slope!"
The bartender inquires, "Are you sure?" To which the yield curve responds, "I'm positive."
I can't take credit for that joke; it was written by BYU economics professor Richard W. Evans.
So, what is the Yield Curve and why does it matter? It is a graphic representation of interest rates on bonds with similar credit ratings and various maturities.
The curve is plotted with short-term interest rates first, then longer maturities out to 20 or 30 years.
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Normally, long-term interest rates are higher than short-term rates, so a normal or positive Yield Curve will slope upward.
The Expectations Hypothesis mentioned in the joke above is a mathematical formula that uses the sum of current and expected short-term rates, plus a risk premium to determine long term rates.
Longer-term bonds pay higher interest rates because there is more risk associated with owning them.
The Yield Curve can change over time; it can flatten, meaning that short-term rates are about the same as long-term rates, and it can also invert, meaning that short-term interest rates are higher than long-term rates.
Currently, three-month US Treasuries are yielding 0.02 percent, and 30-year Treasuries have a yield of 2.68 percent.
The yields in between three months and 30 years increase gradually with maturity, so the Yield Curve is positive, or sloping upward right now. We have a normal Yield Curve.
The big question on everyone's mind is when will the Fed begin raising interest rates?
The minutes from the most recent FOMC meeting were just released and show that more Fed officials are leaning toward keeping interest rates at zero for a longer period of time.
When they do eventually start raising rates, one possibility is that the Yield Curve will flatten, meaning that short-term rates will rise, but long-term rates will not rise as much.
We'll have to wait and see when rates begin to rise, but fixed-income investors should be prepared for a rising rate environment at some point.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.