Understanding Yield Curve Changes

As world records go, the steepest yield curve in history isn’t as easy to grasp as the world’s fastest human or the most home runs in a season. But the yield-curve record set the other day may have a bigger effect on us ordinary folk, as it influences borrowing costs and interest earnings, and may signal good times ahead.

The Financial Times reported that the difference between yields on two- and 10-year Treasury securities briefly surpassed 2.76 percentage points, or 276 basis points, after the Federal Reserve announced Dec. 16 that it would keep short-term rates low even though the economy was improving.

The 276 basis point “spread” beat the previous record of 274 basis points set in August 2003, the Financial Times said.

By the end of the week, the spread was just a smidgeon lower, at 275 basis points, with the two-year Treasury note yielding 0.8% and the 10-year bond 3.55%. A year ago, with the nation in the grips of the financial crisis, the spread was only about 140 basis points, largely because 10-year Treasuries were yielding a mere 2%.

Plotted on a graph, various Treasury yields create a “steep” curve when rates are low on the left and higher on the right. At other times, the curve is “flat” – short- and long-term interest rates are about the same. Occasionally the curve is “inverted” – short-term rates are higher than long-term ones.

While not all experts interpret the various curves the same way, a steep curve like today’s is widely thought to portend good times.

The Fed has kept short-term rates low to make it easier to borrow money, which should stimulate the economy. But the Fed does not have as much influence over long-term rates. Those are set by supply and demand as investors trade bonds, and are influenced in part by what investors expect short-term rates to be in the future. Higher long-term rates mean investors think the economy will perk up enough that the Fed will have to raise rates to curb inflation.