Finance 101 – The Yield Curve
Bond investors receive differing yields depending on the maturity of their investment. By plotting these yields and maturities on a graph, investors can try to make inferences on the market’s expectations for future economic growth. In most instances, investors in long term bonds will receive a higher return than investors in short term bonds as they are exposed to higher risk. Longer term bonds are more sensitive to changes to interest rates, inflation & creditworthiness, and there is an opportunity cost in investing in bonds rather than stocks. When the yield curve slopes upwards (longer-dated bonds yield more than short-dated bonds), the market typically expects economic growth and inflation.
But what if the curve inverts? This is where yields on longer dated bonds fall below yields on short term bonds. In these instances, it implies that the market is pessimistic about economic growth. Every US recession since 1945 has been preceded by an inversion of the yield curve, which means investors place great significance on it. This week markets sold off heavily after the yield curve “inverted”. However, when we actually look at the yield curve, we can see that it is still sloping upwards.