DEFINITION of 'Yield Curve'
A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growthHow it works/Example:
The yield curve shows the various yields that are currently being offered on bonds of different maturities. It enables investors at a quick glance to compare the yields offered by short-term, medium-term and long-term bonds.The yield curve can take three primary shapes. If short-term yields are lower than long-term yields (the line is sloping upwards), then the curve is referred to a positive (or "normal") yield curve. Below you'll find an example of a normal yield curve:
If short-term yields are higher than long-term yields (the line is sloping downwards), then the curve is referred to as an inverted (or "negative") yield curve. Below you'll find an example of an inverted yield curve:
An inverted yield curve occurs when long-term yields fall below short-term yields. Under unusual circumstances, long-term investors will settle for lower yields now if they think the economy will slow or even decline in the future. Campbell R. Harvey's 1986 dissertation showed that an inverted yield curve accurately forecasts U.S. recessions. An inverted curve has indicated a worsening economic situation in the future 6 out of 7 times since 1970.
The New York Federal Reserve regards it as a valuable forecasting tool in predicting recessions two to six quarters ahead. In addition to potentially signaling an economic decline, inverted yield curves also imply that the market believes inflation will remain low.
Finally, a flat yield curve exists when there is little or no difference between short- and long-term yields. Below you'll find an example of a flat yield curve:
A flat curve sends signals of uncertainty in the economy. You shouldn't discount a flat or humped curve just because it doesn't guarantee a coming recession. The odds are still pretty good that economic slowdown and lower interest rates will follow a period of flattening yields.
A look at the yield curve leading up to the 2008 sub-prime crisis: January 2008 - August 2008
Courtesy of US Department Treasury
- September 21, 2008: Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS), the last two of the major investment banks still standing, convert from investment banks to bank holding companies in order to gain more flexibility for obtaining bailout funding.
- September 25, 2008: After a 10-day bank run, the Federal Deposit Insurance Corporation (FDIC) seizes Washington Mutual, then the nation's largest savings and loan, which had been heavily exposed to subprime mortgage debt. Its assets are transferred to JPMorgan Chase (NYSE:JPM).
- September 28, 2008: The TARP bailout plan stalls in Congress.
- September 29, 2008: The Dow declines 774 points (6.98%), the largest point drop in history. Also, Citigroup (NYSE:C) acquires Wachovia, then the fourth-largest U.S. bank.
- October 3, 2008: A reworked $700 billion TARP plan, renamed the Emergency Economic Stabilization Act of 2008, passes a bipartisan vote in Congress. (U.S. bailouts date all the way back to 1792. Learn how the biggest ones affected the economy in Top 6 U.S. Government Financial Bailouts.)
- October 6, 2008: The Dow closes below 10,000 for the first time since 2004.
- October 22, 2008: President Bush announces that he will host an international conference of financial leaders on November 15, 2008.
So as of today, how does the yield curve look like?
Are we really safe for now?
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