The Shape of Things to Come

The single most important statistical “snapshot” the U.S. bond market uses is represented by the yield curve. The yield curve is a graph that plots the interest rates on U.S. government securities ranging from three months to 30 years. Bond managers pay an immense amount of attention to the shape of the yield curve because, in general, it can convey a great deal about the bond market’s expectations for interest rates in the future, and for the economy as a whole. 

Normally, bonds with shorter-term maturities, such as three-month Treasury bills, offer investors a lower interest rate than longer-term bonds because there is less risk associated with them. When investors are tying their money up for a longer period, they are taking more risk and, therefore, demand a higher return. As it turns out, that’s not always the case. Currently, we are experiencing one of those unusual times when the yield curve is out of alignment. 

Tony Albrecht is the director of the fixed income group at Windsor Financial Group, LLC, a Minneapolis-based firm that manages more than $1.2 billion in bonds for individual as well as institutional investors. Albrecht is one of those yield-curve watchers, and offers some insights on shape, slope, and the other vagaries of the bond market.

{Q} Why do bond managers care so much about the yield Curve?

{A} The shape, or slope, of the yield curve will determine potential performance issues for bonds of all maturities. You should care about the shape because it will help you determine where along that continuum between three months and 30 years you want to position your portfolio.

Today, the yield curve is ‘inverted,’ meaning that interest rates are higher on short-term maturities than on long-term obligations.

{Q} What’s going on?

{A} An inverted yield curve tends to predict either an economic slowdown or, in many cases, a recession. One reason this happens is that people like myself who manage fixed-income securities get a sense that the economy is going to slow, and so they go out and purchase longer-term securities at higher interest rates, expecting interest rates to be lower in the future.

That additional demand drives up the price of longer-term bonds, which means that their yield goes down, since the price of a bond and its yield move in opposite directions.

{Q} What do you think the yield curve is saying right now?

{A} I think it’s signaling an economic slowdown. The magnitude of the inversion is important. Right now, the differential between short- and long-term rates doesn’t suggest a recession, but rather something less severe. And keep in mind, of the last six recessions we’ve had since 1970, all six have been preceded by an inverted yield curve.