Flat Yield Curve
A type of yield curve that occurs when the spread between short- and long-term rates for bonds with similar risk characteristics is minimal.
What is the Flat Yield Curve?
The flat yield curve is a type of yield curve that occurs when the spread between short- and long-term rates for bonds with similar risk characteristics is minimal.
In other words, the flattening yield curve represents a market situation where the yields from all maturities become identical.
Graphically, a flattening yield curve, as its name suggests, is a horizontal line showing similar interest rates of debt securities with different maturities but the same quality (see the graphic above for reference).
The yield gap between long-term and short-term bonds narrows if the curve is flattening. For example, a flat yield curve on US Treasury bonds happens when the two-year bond yield rises to 1.94% and the 30-year bond yield drops to 2%.
In this article, we first have an overview of how a yield curve works and yield curve types. Then, we will discuss the reasons behind a flat yield curve.
Next, we will briefly touch on what investors should do when the yield curve flattens and discuss the Barbell Strategy before wrapping up with a list of essential points summarized from the article.
Key Takeaways
- A yield curve is a line connecting interest rates at various maturity dates of a particular debt instrument (e.g., Treasurys or other securities).
- Yield curves come in different shapes. The four types of yield curves are
- Normal Yield Curve
- Steep Yield Curve
- Inverted Yield Curve
- Flat Yield Curve
- Investors use the yield curve as an economic indicator of where the market thinks interest rates will go. In addition, retail and corporate borrowers use the yield curve to gauge the pace of future rises or cuts in interest rates.
- The flat yield curve is a type of yield curve that occurs when the spread between short- and long-term rates for bonds with similar risk characteristics is minimal.
- A flattening yield curve might be caused by the following:
- The Fed’s artificial increase of the short-term rates,
- A potential recession is on the horizon,
- Or lower inflation ahead.
- When the yield curve flattens, the best practice for long-term investors is to ensure their bases are covered by diversifying their investment holdings, setting up an emergency fund, and ensuring their risk exposure marches their tolerance.
- The barbell strategy is an investment and trading technique employed to balance risk and reward by investing in both short-term and long-term securities.
Understanding Yield Curve
Before diving into the flat yield curve, let us review the yield curve.
A yield curve is a line connecting interest rates at various maturity dates of a particular debt instrument (e.g., Treasurys or other securities).
It represents the link between a bond’s term to maturity, the period during which the bondholder will be paid interest on the bond, and the interest rate associated with that term, also known as the yield.
Yield refers to how much reward an investment generates, not including the principal. Below is the yield equation:
Yield = Coupon Payment / Bond Price
As you can see from the above formula, there is an inverse relationship between the bond price and yield. This is because the bond yield decreases when the bond price increases, and vice versa.
The exhibit of yields across different terms helps lenders gauge their investments’ risk and potential profits. While lower yields are typically associated with shorter maturities, higher yields are linked to longer maturities.
But that is not always the case, as yield curves come with different shapes. We will touch on this below.
When journalists talk about the yield curve in the US, they are most likely talking about that of US Treasury securities, including Treasury bills, notes, and bonds issued by the US Department of the Treasury.
In fact, the US Treasuries yield curve is one of the most closely monitored yield curves. Hence, it is referred to as “the” yield curve.
The US Treasuries yield curve indicates how much compensation buyers of government securities are demanding for lending their money over various maturity dates. Backed by the American government, Treasuries are considered a safe investment.
The borrowing rates of Treasuries are determined mainly by investors’ expectations for inflation and economic growth and the Federal Funds Rate (FFR).
Because of the dollar’s central position in the global financial system, the US yield curve not only constitutes investors’ collective judgment of the future trajectory of the world’s largest economy but is also known for alerting downturns before they happen.
It is worth noting that the application of the yield curve goes beyond Treasuries, as investors use it as a reference for almost all other fixed-income investments. This is because the shape of the yield curve can help investors gauge where interest rates are heading in the future.
Types of Yield Curves
Interest rate expectations heavily influence the shape of the yield curve. However, other factors, such as demand for certain securities amongst financial institutions and government intervention, such as quantitative easing (QE), also shape the yield curve.
Below is a brief rundown of the four types of yield curves. Each type indicates a different outlook for the financial markets and the economy.
- Normal Yield Curve: A normal yield curve is an upward-sloping curve in which shorter-term yields are lower than longer-term yields. It suggests investors expect the economy to perform well in the future and that central banks will lift interest rates to “cool” the economy.
- Steep Yield Curve: Despite looking alike, a steep yield curve has a steeper slope than a normal yield curve. In other words, the difference between short-term and long-term yields is wider in a steep curve than in a normal curve. A steep yield curve suggests investors anticipate a robust economy to prevail over the longer term. Moreover, it usually occurs ahead of a period of economic expansion.
- Inverted Yield Curve: An inverted yield curve occurs when the yields of longer-term bonds are lower than that of shorter-term bonds. Instead of sloping up, the yield curve slopes down in this case. It is the opposite of a normal yield curve. An inverted yield curve is usually considered an economic indicator of a near-future downturn or recession.
- Flat Yield Curve: A flat yield curve is a yield curve in which the short-term yields are similar to long-term yields.
At times, a flat yield curve may have an elevated middle portion, where the mid-term yields are higher than both short-term and long-term yields. That is a humped yield curve.
A flat or humped yield curve usually forms during a transition from positive to inverted or inverted to positive.
In terms of usefulness, investors use the yield curve as an economic indicator of where the market thinks interest rates will go. For retail and corporate borrowers, the yield curve is used to gauge the pace of future rises or interest rate cuts.
This is because what the bond market thinks will happen to interest rates in the future directly affects what could happen to mortgage rates for individuals and borrowing rates for companies.
Reasons for Flat Yield Curves
When a yield curve flattens, it becomes less curvy as the gap between the short-term and long-term yields becomes narrow. So why and how does a yield curve flatten, and what is its implication for financial markets?
Many reasons can lead to a flattening yield curve. Naturally, a flat yield curve can be caused by either the increasing short-term or long-term rates falling. Below are some situations that have flattened the yield curve historically:
1. The Fed’s Monetary Policy
A flattening yield curve might be caused by the Fed’s artificial increase in short-term rates.
The Fed promotes maximum employment, stable prices, and moderate long-term interest rates by implementing monetary policy measures as needed. For instance, it can alter the overnight FFR rate, causing financial institutions to change the interest rates they offer to the public.
If the Fed increases the coupon rates of the bonds, it will take a long time for the new rate to reflect in the yield curve, as the Fed has a lot of influence on the left side of the curve, but the right side is harder to control.
This is because the rates of all outstanding long-term bonds won’t change to reflect the new rate until they mature. Hence, the Fed’s increase in short-term rates flattens the yield curve by lifting the left side of the curve.
2. Potential Recession on the Horizon
While the Fed can only influence the left side of the curve, there is something that can cause the right side of the curve to move quickly.
As mentioned above, there are two parts to the yield equation – the bond’s coupon payment based on the Fed’s interest rate and the bond price.
If people start demanding more long-term bonds, buying on the right side of the yield curve will increase bond prices. When the long-term bond prices go up, their corresponding yields decrease, causing the yield curve to flatten.
When this happens, it typically is a bad thing. Why?
The flattening yield curve indicates that investors have bought long-term bonds to the point where the yield is no more attractive than short-term bonds. In other words, investors believe that there is some greater risk out there that supersedes the risk of long-term bonds.
This could be because investors expect future interest rates to fall, so they are rushing to secure current rates or because they expect other investments to perform poorly. Regardless, it all comes from expectations that the economy will slow down.
If the situation in which investors flock to buy long-term bonds doesn’t improve, it could push the flattening curve into an inverted one.
The inverted yield curve suggests that the concern over the economy is so great that investors rather accept lower returns to lock in a long-term US government bond yield (which is the safest asset class) than put their money elsewhere.
3. Lower Inflation Ahead
Furthermore, if market participants anticipate lower inflation in the future, the yield curve might also flatten. Normally, investors and lenders want higher long-term yields to compensate for the impact of inflation on their long-term investments.
However, because inflation is predicted to drop, investors won’t be as concerned about the impact of inflation on their long-term investment as they would otherwise be during normal times.
Instead, they will evaluate the opportunity cost of a long-term investment versus a short-term one. When a yield curve flattens, investors receive the same amount of money regardless if they invest in short-term or long-term securities.
As a result, many would choose to put their money in short-term securities rather than long-term bonds because they can gain not only identical profit but also be free of the hazards of having their funds held up in a long-term bond, thereby flattening the curve.
The Flat Yield Curve – An Indicator for Lenders
It’s worth noting that one should not use the yield curve as a crystal ball and read it as an exact science. This is because the flat yield curve could come three months or three years before a recession.
Not to mention that sometimes the curve would only remain flat for a few weeks, and it would return to normal. In addition, what happened in the past isn’t necessarily going to happen in the future.
Hence, while investors can hedge their risks, trying to track down the next recession and timing the markets is often a bad practice. So if investors cannot avoid a recession, what should they do to prepare?
The best practice for long-term investors is ensuring their bases are covered. This can be done through diversifying their investment holdings, setting up an emergency fund, and making sure their risk exposure marches their tolerance.
At the end of the day, if an investor holds a high-quality portfolio, they typically don’t have to worry about the short-term implications of an economic downturn.
That being said, it’s still important to know the barbell strategy, as many investors use it to combat a flattening yield curve and manage risks.
The Barbell Strategy
The barbell strategy is an investment and trading technique employed to balance risk and reward by investing in short-term and long-term securities. It is normally used in fixed-income investing, even though it can also be applied in equity investing.
Typically, long-term securities comprise half of a barbell strategy’s portfolio, while short-term securities constitute the other half. As a result, investors may benefit from the barbell strategy when the yield curve flattens or if the Fed raises the Fed Funds Rate.
The logic behind the strategy is to mitigate risk while maintaining overall return by pairing high-risk but high-return investments (long-term securities) with lower-risk, lower-yield investments (short-term securities).
The barbell strategy is usually utilized in fixed-income investing when investors want to avoid having too much of their funds locked in long-term bonds should the interest rates increase.
If the Fed lifts the rates, investors can free up cash to invest in new, higher-yield bonds, as they have part of the portfolio in short-term bonds.
On the contrary, if the rates drop, investors would benefit as they still have half of the portfolio tied up in the higher-yield long-term bonds.
This strategy allows the investor to have some flexibility to react to bond market fluctuations. However, because of the maturity terms of long-term bonds, the portfolio may see a significant drop if long-term rates rise dramatically.
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