What Is The Yield Curve? Why Is It Important? 3
When times aren’t “normal” (like now), the shape of the yield curve changes, which is why it is so closely watched by market participants.
How and why does it change?
The first major change a yield curve undergoes when economic conditions start to sour is what is known as flattening.
This is most easily observed graphically.
Flattening occurs when short term yields rise more relative to long term ones, or, long term yields fall more than short term ones.
The converse is true when economic conditions start to improve in the aftermath of a recession. In this case, the yield curve is said to steepen.
Steepening occurs when short term yields fall by more than long term yields, or, when long term yields rise by more than short term ones.
The difference between short and long term yields, known as a “spread”, measures the degree of flattening or steepening.
Spreads can be calculated between any two points of the yield curve. One of the most commonly followed spreads is the one between US 2y and US 10y yields, or the 2s10s.
The 2y in this spread represents the short end of the curve, and the 10y the long end, which makes the 2s10s a good indicator of the market’s expectations for future growth.
Should the 2s10s decrease, it means that the yield curve is flattening. This implies that the market is expecting lower inflation from economic growth in the long term (10 years) relative to the short (2 years).
The more drastic the flattening, that is the closer to 0 a spread gets, the higher the potential for a recession in the near future.
When a spread falls below 0, the yield curve is said to be inverted between those points, as it was in early April.
Why does the yield curve change in such ways?
To be continued…
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