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Talking Money: Yield Curve

Fixed-income investors can get a picture of the long and short on interest rates from the yield curve. As Kyle Tetting explains in a Money Talk Video, the yield curve also can suggest investment strategies as its shape shifts over time. Kyle spoke with Joel Dresang. The transcript of the video is below.

Joel Dresang: Kyle, a prime tool for people who are bond investors or fixed-income investors is the yield curve. Can you explain for investors what that is?

Kyle Tetting: It really is what it sounds like. It’s a curve on a graph reflecting the interest rates on Treasury bonds of various maturities.

So everything from the overnight or the 3-month T bill all the way out to 30-year Treasuries. It looks at, again, what those interest rates are for each of those offerings.

Joel: And typically, you’d get a higher interest rate the greater the maturity because investors are committing to a longer period of time.

Kyle: That’s absolutely true.

Joel: So, Kyle, typically the yield curve slopes up for the longer maturities, but it’s not always the case.

Kyle: It doesn’t have to be. There are a couple of market environments that can really cause the yield curve to flatten out and even sometimes eventually invert, where longer-term rates are actually below the shorter-term rates. It’s very abnormal. And when it does occur, it almost always signifies a recession.

Joel: Kyle, what do you typically see as the difference on a yield curve, and what are you seeing now?

Kyle: When we follow the yield curve, what we’re really looking at is the difference between shorter-term rates and longer-term rates. So we might benchmark the 3-month T-Bill versus the 10-year Treasury or versus the 30-year Treasury. Right now, we see a pretty steep yield curve – about 335 basis points or 3.35% difference between that long-term 30-year rate and the 3-month rate. Historically, that’s probably closer to 3%. And, ultimately, that’s going to start to normalize a little bit. We expect that the shorter term rates, over time, are going to be allowed to float higher.

As we know, right now the Federal Reserve has kept short-term rates quite low: the overnight rate at about 0% and even the 3-month rate not much above that. But over time, those things, as long as the economy continues to improve, those things should start to change.

Joel: So what strategy do you have, knowing that about the yield curve?

Kyle: The big issue we have for bond investors is that we expect over time rates as a whole to rise. But one of the things that we can do is understand that short-term rates are likely to rise a little bit faster than long-term rates because the Fed has intervened on the short end – and because their intervention on the long end has started to unwind now.

So there is probably a point on the yield curve where you’re going to see kind of like a teeter-totter. One end starts to move higher while the other end comes down. Now the overall rates are going to come up together. But what you’ll see is that that short end probably is going to move up quicker than that long end because it’s going to start to normalize a little more.

Joel: So you want to find that pivot point in there just so that you’re not moving as much.

Kyle: Absolutely. Yeah. And we still expect that even at the pivot point, rates are going to move higher. But they’re probably going to move higher at a rate that’s much different than on the short than on the long end.

Joel: And you keep your eye on the yield curve, but you’re not expecting rates to go up very quickly.

Kyle: We certainly don’t expect the Fed to make any major changes to overnight rates anytime soon. And we’ve seen the market respond a little bit to Fed tapering. But, of late, that’s slowed down. So certainly we don’t expect any significant changes in the next 12 to 18 months.

Kyle Tetting is director of research at Landaas & Company.

Joel Dresang is vice president-communications at Landaas & Company.

Money Talk Video by Peter May
(initially posted June 11, 2014)
To foster financial literacy, the Talking Money feature covers common terms and concepts used in personal finance and investing. For more Talking Money terms, please click here.

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