Lesson 15

What is a Yield Curve

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Lesson 15 Objectives

Lesson Objective 1: What is a yield curve

Lesson Objective 2: How can I use a yield curve to predict market behavior

Lesson 15 Executive Summary

All stock investors want to know what the future hold, so they can make the best investments today. While this is clearly impossible, we have some tools that can assist the investor’s qualified guess. One of them is the yield curve.

A yield curve compares the interest rate and the term (the time before the bond matures). A positive yield curve is upwards sloping. In other words, the further we are out in the future, the higher the interest rate (or yield). An example could be that you would receive a 3% coupon on a 5-year bond, and 5% coupon on a 30-years bond. Another type of yield curve is a flat yield curve, or even an inverse yield curve.

The federal government’s position on the direction of the economy is reflected in the shape of the yield curve. For instance, if the yield curve is flat or inversed, the government is really saying that they want to make money borrowing expensive, thereby slowing down the economy.

On the other hand, In times of recession you will see a positive yield curve. The reason is the federal government wants to encourage spending – therefore getting money flowing through the economy once again. Not only can people borrow cheap, they only have limited incentive in the short term to save money.

One thing to keep in mind when learning about the yield curve, is that the yield curve is a key input to the valuation of stock. We will dig much more into valuation in lesson 21.

Later in this lesson we go back in time to see if there is empirical evidence for claiming the yield curve can be a predictor of the stock market. Based on a time period since the 1990s we can actually observe different points in time that the yield curve has proven to be a reliable indicator in both good and bad times. Even before the recent financial crisis, a yield curve aiming to slow down the economy can actually be observed.

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New Vocabulary

Yield Curve

Comparing the yield you can get from an investment in government bonds with the term (duration until the bond expires). It serves as a predictor of future stock market performance.

What is a Yield Curve - Lesson Transcript

Before everything else, let me inform you that throughout this lesson, you will need to refer to the video as you read along in order to fully understand the yield curve.

When you get into stock and bond investing, everyone wants to predict the future. However, it is almost impossible in most cases, but one of the tools that helps us analyze where the current market condition is and where it might be going is the yield curve.

A yield curve is an important tool that helps you to be a successful stock and bond investor. What is a yield curve?

On the screen is a generic yield curve. If you look over to the left, there’s the yield and that goes on the Y axis and it runs from 1% up to 5.5% on this particular graph. That yield is your interest. As you look at the bottom on the X axis, that’s the term (what you learned in course 1 about bonds – the term is nothing more than years until the bond matures). This chart is a comparison between a yield and the term.

At this particular chart, this is considered a positive yield curve because it starts with the short term of one year and the yield is about 2.3%. As you go further into the term and across the chart, that yield continues to increase, which naturally makes sense. Not all yield curves are like this. You might think that the yield would naturally increase with the length of the term, but that doesn’t always happen.

Again, for one year, the yield is about 2.3% and as you would go over to the third year mark, it is around 5%. You would lend your money for 30 years and get 5% on your money. You can see how that changes over time.

Look at another one. When you look at the next yield curve, this is considered a flat yield curve. If you would lend your money for one year, you would get 5% interest at about 4.9% interest on this chart. If you lent it for 30 years, you would always make the exact same yield on your money, which doesn’t really make a lot of sense. Right now, all you have to know is read the numbers off the chart. If you bought a 15-year bond, look at this chart and go from 15 years until you hit the line and you see that you’d get a 5% yield.

A chart that’s really uncommon to see is an inverse yield curve. If you bought a bond at a 1-year term, you’d get a 4% yield. A 2-year bond would be a 5% yield. Just so you know, if it’s one year, it’s not considered a bond, but a bill. The proper terminology is a bill.

As you go into the duration, you can see how this chart is going down, so the third year bond is below 3.5%, but if you’re lending your money in the short term, you’re actually making more, so that doesn’t make sense. You’ll understand this discrepancy as this lesson goes further.

May 11, 2012 at the US Treasury yield curve. When you look at this yield curve, the short term has low interest rates. Interest rates are so low in the short term, because the FED is trying to spark the economy and get people to spend. There’s still a lot of fallout from the 2008 crash, which still affects 2012. If you look at the one year mark for the yield, you can see it’s below .5%, which is extremely low. As you can look out to the third year, it’s only 3%.This is where the current market condition on May 11, 2012 was.

What’s important about the yield curve? That yield curve is a valuable tool that can help you as an investor to understand where the FED is trying to steer the economy. The yield curve is flat. Assume that the whole yield curve is flat at 5%. When you think about how the FED thinks, they are trying to slow down the economy at this point. They’re making the price for borrowing money expensive especially for the person in the short term and the long term at 5%.The forecast in the long term is exactly the same as it is in the short term. You’re typically in a flat or an inverse yield curve whenever the economy is doing well. The FED tries to slow down the economy, because they don’t want a big bubble to occur. When it gets too big, it pops and everything goes into recession.

Now, when the FED is trying to create spending and spark the economy, a chart looks like this. In the short term, the money to borrow is really cheap. When it’s cheap, people spend. When you look at May 11, 2012, the FED is trying to create spending in our economy by keeping those interest rates very low. Even at the 30 year mark, it’s only at 3% which is extremely low. They still project the economy is in a recession.

When you calculate the intrinsic value of a stock in lesson 21, which is the next unit, you’ll be using the value found on the yield curve for the 10-year federal note. If you went back to the yield curve here and looked at the 10-year mark, you can see that it’s approximately 1.7-1.8. That might not make much sense now, but as you’re looking at this chart you’ll see how it applies during your intrinsic value calculation.

Go to the US Treasury Website and see what I’m doing here. The link is on the screen. Here’s our chart and I’ll show you how the yield curve changes over time with the Dow Jones. As you can see, I’ve got the screen split in half here, and I have the US Department of Treasury and the Dow Jones form 1995-2000. If you don’t remember that area, during that time, the economy was going through a boom from the Internet bubble. At around the year 2000, we saw the peak of the internet bubble. Let’s look at how the treasury yield curve looked back at the beginning of 2000.

You can change the dates right here, we put in January 2000. Hit go, and there’s our chart. This is what the yield curve looked like back in 2000. The yield back then was at 6-7%. Back in 2000, the FED knew what was going on, there was a nice flat yield curve and they were trying to slow down the economy using high interest rates.

Let’s look what happened after the year 2000. I adjust the inputs and now it’s displaying from 2000-2011. You can see back in 2000, the economy was booming. Let’s see 2001. Change the date to 2001 and click go. As you can see, it’s actually starting to get a little bit inverted, which I said before is very rare.

When you see that inverted yield curve, you know there’s something bad probably coming down the pipe where the FED is expecting interest rates to go lower. They were predicting a recession at that point. Almost the 6% yield at the 3-month bill and as you go out to the 30-year, it’s actually down to 5.4. That time frame was right here 2001, right before the 2002 crash. It wasn’t a deep crash, but it was somewhat of a crash back then. See what happened to the yield curve in 2002. Look at what the yield curve looked like. It was very low in the short term and in the long term. The FED was predicting that so the interest rates rise again over that 30-year period. In the short term, they got to keep them low.

In 2003, there was a deep recession. It was even lower, so they were trying to spark the economy.

Look at the really deep recession in 2008. We’ll start at 2006 to see how the yield curve changes over time. The FED already saw that the economy had recovered and the yield curve started to go flat.

In 2007, you’ll see that 5%-5.5% yield curve will get higher. We’re right here on the peak. You can see that it’s even higher to 5% compared to where it was before. It was slightly inverted in 2007.

Let’s look at what happened in 2008. That’s when they started getting the crash and you’ll see that the FED’s already preparing for it. You can see it’s starting to get that positively sloped yield curve. That’s the FED tipping their hat that there’s recession coming. How deep of a recession, nobody know that or can predict that, but you do know that there’s somewhat of a recession coming. Then as we go to 2009, you’ll see a drastic change. Almost down to 0% in the short term and on your long terms it’s still very low rate at 3%.

Hopefully that gives you an idea on how to read the yield curve and how you can use that as a predictor for what’s coming next and how the FED basically tells you how to look at the economy in the direction that it’s going. I hope that really works out well for you. Remember that whenever we get into the next section, we’re going to be coming over here to the 10-year mark and moving straight down on this yield curve and reading that value, which, for this date, in 2009 of January, was 2.46%.

Let’s quickly pull up here where we’re at in 2012. If you come over to the 10-year, you come up and it’s at 1.98%. When we get into the next section, were’ going to be using around 2% to calculate the intrinsic value of our stocks. That’s based on the current economic conditions. As time marches on that rate will likely increase.

In this lesson, students learned how to read a yield curve. When looking at the yield curve, it has two major components - yield and term. The yield is found on the y axis and it represents the amount of interest that we'll be paid for owning a particular bond. The term is found on the x axis and it represents the duration we would hold the bond at the specified yield.

Although reading a yield curve is fairly straight forward, many people fail to recognize its importance in determining the direction of the economy. As you saw in the video, the yield curve is flat or slightly inverted when a financial market is at its peak. Slightly before and after a market collapses, you would find the yield curve slope in a positive direction.

When we move into Course 2, Unit 3, it'll be important to continue looking at the yield curve as we determine a metric for our "zero risk" investment - the 10 year federal note.