If you invest in equities, you should keep an eye on the bond market. If you invest in real estate, you should keep an eye on the bond market. If you invest in bonds (or bond ETFs), you should definitely keep an eye on the bond market.

The bond market is a great predictor of future economic activity and future levels of inflation, both of which directly affect the price of everything from stocks and real estate to household items. In this article, we'll discuss short-term vs. long-term interest rates, the yield curve, and how to use the study of yields to your advantage in making a broad range of investment decisions.

Interest Rates and Bond Yields

Interest rates and bond yields are highly correlated, and sometimes the terms are used interchangeably. An interest rate might be thought of as the rate at which money can be borrowed in the form of a loan and, while most bonds have an interest rate that determines their coupon payments, the true cost of borrowing or investing in bonds is determined by their current yields.

A bond's yield is simply the discount rate that can be used to make the present value of all of a bond's cash flows equal to its price. A bond's price is the sum of the present value of each cash flow that will ever be received from the investment.

The return from a bond is commonly measured as yield to maturity (YTM). YTM is the total annualized return received by the investor, assuming that he or she holds the bond until it matures and reinvests coupon payments. YTM thus provides a standard annualized measure of return for a particular bond.

Short-Term vs. Long-Term

Bonds come with varying maturity periods, which can range from as little as one month to up to 30 years. So, when speaking of interest rates (or yields), it is important to understand that there are short-term interest rates, long-term interest rates and any number of points in between. While all interest rates are correlated, they don't always move in step.

For example, short-term interest rates might decrease, while long-term interest rates might increase, or vice versa. Understanding the current relationships between long-term and short-term interest rates (and all points in between) will help you make educated investment decisions.

Short-Term Interest Rates

Short-term interest rates worldwide are administered by nations' central banks. In the United States, the Federal Reserve Board's Open Market Committee (FOMC) sets the federal funds rate, the benchmark for other short-term interest rates. The FOMC raises and lowers the fed funds rate as it sees fit to promote or curtail borrowing activity by businesses and consumers.

Borrowing activity has a direct effect on economic activity. If the FOMC finds that economic activity is slowing, it might lower the fed funds rate to increase borrowing and stimulate the economy. However, the FOMC must also be concerned with inflation. If the FOMC holds short-term interest rates too low for too long, it risks igniting inflation by injecting too much money into an economy that is chasing after fewer goods.

The FOMC's dual mandate is to promote economic growth through low-interest rates while containing inflation; balancing both goals is a difficult task.

Long-Term Interest Rates

While short-term interest rates are administered by central banks, long-term interest rates are determined by market forces. Long-term interest rates are largely a function of the effect the bond market believes current short-term interest rates will have on future levels of inflation. If the bond market believes that the FOMC has set the fed funds rate too low, expectations of future inflation increase, which causes long-term interest rates to increase in order to compensate for the loss of purchasing power associated with the future cash flow of a bond or the principal and interest payments on a loan.

On the other hand, if the market believes that the FOMC has set the fed funds rate too high, the opposite happens – long-term interest rates decrease because the market believes future levels of inflation will decrease.

Reading the Yield Curve

The term "yield curve" generally refers to the yields of U.S.Treasury bills, notes, and bonds in sequential order, from shortest maturity to longest maturity. The yield curve describes the shapes of the term structures of interest rates and their respective times to maturity in years. It is frequently displayed graphically, with the time to maturity located on the x-axis and the yield to maturity located on the y-axis of the graph.

For example, treasury.gov provided the following yield curve for U.S. Treasury securities Dec. 11. 2015:

Yield Curve for U.S. Treasury Securities

The above yield curve shows that yields are lower for shorter maturity bonds and increase steadily as bonds become more mature.

With the understanding that the shorter the maturity, the more closely we can expect yields to reflect (and move in lock-step with) the fed funds rate, we can look to points farther out on the yield curve for a market consensus of future economic activity and interest rates. Below an example of the yield curve from January 2008.

U.S. Treasuries

Bills Maturity Date Discount/Yield Discount/Yield Change
3-Month 04/03/2008 3.12/3.20 0.03/-0.027
6-Month 07/03/2008 3.10/3.21 0.06/-0.074
Notes/Bonds Coupon Maturity Date Current Price/Yield Price/Yield Change
2-Year 3.250 12/31/2009 101-011/2 / 2.70 0-06+/-0.107
5-Year 3.625 12/31/2012 102-04+ /3.15 0-143/4 / 0.100
10-Year 4.250 11/15/2017 103-08 / 3.85 0-111/2/ -0.044
30-Year 5.000 5/15/2037 110-20 / 4.35 0-051/2 / -0.010

Figure 1: Yield Curve January 2008

Source: Bloomberg.com

The slope of the yield curve tells us how the bond market expects short-term interest rates (as a reflection of economic activity and future levels of inflation) to move in the future. This yield curve is "inverted on the short-end" and suggests that short-term interest rates will move lower over the next two years, reflecting an expected slowdown in the U.S. economy.

Using the above yield curve as an example, it should not be interpreted to say that the market believes that two years from now the short-term interest rates will be 2.7% (the two-year yield as shown above). There are other market tools and contracts that more clearly show a "predicted" future rate of a benchmark like the fed funds rate. The yield curve is best used to make general interest rate forecasts, rather than exact predictions.

Types of Yield Curves

There are several different formations of yield curves: normal (with a "steep" variation), inverted and flat. All are shown in the graph below.

Normal Yield Curve

As we can see by following the orange line, a normal yield curve starts with low yields for lower maturity bonds and then increases for bonds with higher maturity. A normal yield curve slopes upwards; however, once bonds reach the highest maturities, the yield flattens and remains consistent.

As the term "normal" suggests, this is the most common type of yield curve. Longer maturity bonds usually have a higher yield to maturity than the shorter-term bonds. For example, assume a two-year bond offers a yield of 1%, a five-year bond offers a yield of 1.8%, a 10-year bond offers a yield of 2.5%, a 15-year bond offers a yield of 3.0% and a 20-year bond offers a yield of 3.5%. When these points are connected on a graph, they exhibit a shape of a normal yield curve.

Such a yield curve implies a stable economic condition and prevails for the longest duration in a normal economic cycle.

Steep Yield Curve

As we can see by following the blue line, a steep yield curve is shaped like a normal yield curve, except with two major differences. First, the higher maturity yields don’t flatten out at the right but continue to rise. Second, the yields are usually higher compared to the normal curve across all maturities.

Such a curve implies a growing economy moving towards a positive upturn. Such conditions are accompanied by higher inflation, which often results in higher interest rates. Hence, lenders tend to demand high yields which get reflected by the steep yield curve. The longer-duration bonds tend to become risky, so the expected yields are higher.

Flat Yield Curve

A flat yield curve, also called a humped yield curve, is represented by almost similar yields across all maturities. A few intermediate maturities may have slightly higher yields, which cause humps to appear on the flat curve. These humps are usually for the mid-term maturities: six months to two years.

As the word "flat" suggests, this yield curve is a shape in which the short- and long-term yields to maturity are similar to each other. For example, assume a two-year bond offers a yield of 6%, a five-year bond offers a yield of 6.1%, a 10-year bond offers a yield of 6% and a 20-year bond offers a yield of 6.05%. The plot would exhibit a flat yield curve formation.

Such a flat/humped yield curve implies an uncertain economic situation. It includes conditions like the one after a high economic growth period leading to high inflation and fears of a slowdown, or during uncertain times when the central bank is expected to increase interest rates. Due to high uncertainty, the investors become indifferent to maturity periods of the bonds and demand similar yields across all maturities.

Inverted Yield Curve

The shape of the inverted yield curve, shown on the yellow line, is opposite to that of a normal yield curve—sloping downward. An inverted yield curve is one in which short-term interest rates exceed long-term rates; short maturities have higher yields, and vice versa.

For example, assume a two-year bond offers a yield of 5%, a five-year bond offers a yield of 4.5%, a 10-year bond offers a yield of 4% and a 15-year bond offers a yield of 3.5%. These yields would exhibit an inverted yield curve shape.

An inverted yield curve is rare but is strongly suggestive of a severe economic slowdown. Historically, the impact of an inverted yield curve has been to warn of a pending economic recession.

Historical Yield Curve Accuracy

Yield curves change shape as the economic situation evolves, based on developments in macroeconomic factors like interest rates, inflation, industrial output, GDP figures and balance of trade. While the yield curve shouldn't be used to predict exact interest rate numbers and yields, closely tracking its changes allows investors to rightly anticipate, and benefit from, short- to mid-term changes in the economy. Normal curves exist for long durations, while an inverted yield curve is rare and may not show up for decades. Yield curves that change to flat and steep shapes are more frequent and have reliably preceded the expected economic cycles.

For example, the October 2007 yield curve flattened out, and it was followed by a global recession. In late 2008, the curve became steep, which indicated the upcoming growth phase of the economy following the Fed’s easing of the money supply.

Using the Yield Curve to Invest

Interpreting the slope of the yield curve is a very useful tool in making top-down investment decisions. for a variety of assets.

For example, if you invest in equities, and the yield curve says to expect an economic slowdown over the next couple of years, you might consider moving your allocation of equities toward companies that perform relatively well in slow economic times, such as consumer staples. On the other hand, if the yield curve says that interest rates are expected to increase over the next couple of years, an allocation toward cyclical companies such as luxury-goods makers or entertainment companies makes sense.

If you invest in real estate, you can also use the slope of the yield curve. For example, while a slowdown in economic activity might have negative effects on current real estate prices, a dramatic steepening of the yield curve (indicating an expectation of future inflation) might be interpreted to mean future prices will increase.

Or say you're into fixed-income securities. When the yield curve is expected to become steep—signaling high-growth periods and high inflation – savvy investors tend to short the long-term bonds (because they don't want to be locked into a return whose value will erode with rising prices) and buy the short-term securities. If the yield curve is expected to become flat, it raises fears of high inflation with the economy slipping into recession; with inflation worries and recession fears subduing each other, investors tend to take short positions in short-term securities and ETFs and go long on long-term securities.

You could even use the slope of the yield curve to help you decide if it's time to purchase that new car. If economic activity slows, new car sales are likely to slow and manufacturers might increase their rebates or other sales incentives.

The Bottom Line

Bond market studies shouldn't be left to just the fixed-income investors. Because yield curves have historically offered good indications for economic changes, reflecting the bond market's consensus opinion of future economic activity, levels of inflation and interest rates, they can help investors make a wide range of financial decisions. It's very difficult to outperform the market, so prudent investors should look to employ valuable tools like the yield curve whenever possible in their decision-making processes. Remember, timing is everything.