The Yield Curve: What is it and why is it important?

The “yield curve” is simply the difference between short and long-term interest rates. Short-term rates (2-year bond) are greatly influenced by central bankers (the Federal Reserve) in their attempts to stimulate the economy, support employment and contain price inflation. Long-term rates (20-year bond) are dictated by the market and forces associated with supply and demand. Under normal circumstances, rates are higher for longer term debt because of the additional risk involved with money that is tied up for a longer time. It makes sense that a person would want to be paid more interest when their money is committed for twenty years, as opposed to two. This extra interest for longer term debt is called the “yield premium”. Implicit in this concept is the presumption that the economy will grow over the next twenty years and there will be future opportunities to put money to work, thereby resulting in future earnings, appreciation of stocks and receipt of bond interest. These opportunities are lost when a person’s money is committed to another investment. This is called “opportunity cost” and is at the heart of the matter.

When the difference between short- and long-term interest rates is large, it is said that the yield curve is “steep”. A steep yield curve suggests the potential for future economic growth thereby requiring a significant premium in the form of higher interest payments for money to be committed into a long-term-debt instrument, like a bond. When the difference between short- and long-term rates is small, it is said that the yield curve is “flat”. This suggests that the market does not see future growth opportunities and is willing to commit money in the future for the same or similar rates that are available today. Believe it or not, the yield curve can invert, and short-term rates become higher than long-term rates.

Why is all of this important?

The yield curve is important for two principle reasons. First and foremost, it gives us insight into what the totality of all investors see within the economy. If you believe in the efficiencies of free markets, then the aggregate opinion of all market participants is the best evidence of what is really going on. This concept is similar to the idea in our justice system that twelve jurors are more likely than just one or two to sift through evidence and determine a fair outcome to a trial. The point being, if the market is not seeing opportunities for growth in the future, we better pay attention.

The second reason the yield curve is important is a by-product of the first. The yield curve has a great impact on the money supply within the economy. Another way to put it is that the yield curve influences the ability of individuals and businesses to obtain traditional bank loans. Banks borrow money at short-term rates, either from the Federal Reserve Discount Window or from its depositors. It then turns around and loans money to people like you and me at higher rates. If the market is not requiring higher rates (yield premium) due to concerns about future growth, then banks are forced to loan money at lower rates. The result is that the bank cannot make as much money and its margins are compressed. In a very real sense, the flatter the curve the less incentive banks have to make loans. Loans are a risk for a bank and if it can’t make money for assuming the risk, bankers quit taking the risk and quit making loans. When banks stop making loans, or make the conditions of the loan so restrictive that consumers and businesses can’t borrow, the economy suffers. People can’t buy houses and cars. Businesses can’t reinvest and grow. The economy stagnates. In many ways, the yield curve thus becomes a circular self-fulfilling prophecy. What came first, the chicken or the egg?

This short post is an over-simplification of many complicated financial concepts, which have a bearing on the yield curve and the resultant effect on the economy. Suffice to say, the yield curve matters and we watch it at Cabana.

– G.  Chadd Mason, CEO

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