The US Treasury yield curve relates the yields of short-term Treasury bills to long-term Treasury notes and bonds. The United States Treasury Department issues Treasury bills with terms of less than one year. It provides notes with terms of two, three, five, and ten years. It issues bonds with periods of 20 and 30 years. Treasury securities are commonly referred to as notes, or Treasurys for short.
Understanding Treasury Yields
The Treasury Department establishes a fixed face value and interest rate for Treasury securities, then auctions them off. When demand is high, prices rise above the face value, reducing the yield since the government only pays back the face value plus the agreed interest rate.
Conversely, when demand is low, prices drop below the face value, increasing the yield as buyers pay less for the bond but still receive the same interest rate. Treasury bond prices and yields move inversely. Treasury yields fluctuate continuously due to daily reselling on the open market.
Short-term Treasury bills typically offer lower yields compared to medium-term notes and long-term bonds.
It's difficult to see someone buying a 30-year Treasury bond and then sitting on it with only a few percentage points of return. However, some investors are so concerned about losses that they are willing to sacrifice a higher return on investment in the stock market or real estate. They understand the federal government will not default on the loan.
In an uncertain world, many investors are ready to give up a larger return for that guarantee. That's significant, even when investors don't buy Treasurys and hold them. They resale them in the secondary market. This is where Treasury holders sell their securities to institutional investors including pension funds, insurance corporations, and retirement mutual funds.
Three Types of Yield Curves
Different types of yield curves serve as valuable indicators of investor sentiment towards the economy, aiding in assessing economic growth.
Normal Yield Curve: When investors exhibit confidence, a normal yield curve emerges. This scenario sees a significant rise in yields for short-term notes as investors favor them over long-term investments, anticipating rapid economic expansion. Correspondingly, mortgage rates and other loans align with this curve. Opting for a 15-year mortgage over a 30-year one becomes advantageous due to lower interest rates, provided the payments are manageable.
Flat Yield Curve: A flat yield curve manifests when yields remain uniformly low, signaling expectations of sluggish growth. This situation may stem from conflicting economic signals, with some investors optimistic about growth while others remain cautious. In such instances, the advantage of choosing a 15-year mortgage diminishes, prompting consideration of a 30-year loan while directing savings towards retirement or home ownership.
A flat yield curve also suggests reduced lending activity by banks, as the marginal returns on longer-term loans fail to justify the associated risks. Consequently, banks gravitate towards conservative lending practices, preferring low-risk investments like money market instruments and Treasury notes.
Inverted Yield Curve: The inversion of the yield curve often precedes economic downturns, indicating pessimism among investors about the near-term economic outlook. This phenomenon occurs when short-term bond yields surpass those of longer-term bonds, reflecting a preference for long-term investments despite lower yields. Notably, yield curve inversions preceded both the 2001 and 2008 recessions, serving as a harbinger of economic contractions.
Conclusion
Market participants must evaluate the yield curve in order to predict the future state of the economy and make informed economic decisions. The curve is simply depicted by entering current yields into an Excel spreadsheet and making a graphic. Yield curves are also used to calculate yield to maturity (YTM) for specific issues and play an important role in credit modeling such as bootstrapping, bond valuation, and risk and rating assessments.
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