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Finance: What is the Difference Between Normal, Inverted and Flat Yield Curves, and What Do They Tell Us? 89 Views


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What is the difference between Normal, Inverse/Inverted, and Flat Yield curves and what do they tell us? Normal yield curves represent long-term interest rates being more favorable than short-term rates. Inverted curves represent the opposite, that short-term rates are more favorable. When this happens, usually something pretty drastic is happening in the market like a crash. If the yield curve is flat, rates are about the same. So, this flat period happens between normal and inverted, and is kind of a warning that a recession may be on the horizon.

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Transcript

00:00

Finance, a la Shmoop. [title page]

00:03

What's the difference between normal, inverted, and flat yield curves, and what to they tell

00:09

us?

00:10

All right, well let's start with the basics.

00:13

Yield curve... ooh, sexy term. [guy talks about yield curves]

00:15

Say it a lot and people will think you know a lot about finance.... or that you're really [people are pretty impressed]

00:19

into slowing down while making gradual left turns. [pig thanks slow driver]

00:22

But in finance, a yield curve is just a graphic representation of bond yields, from "maturing [yield curves defined]

00:29

soon" to "not maturing for a really long time."

00:32

So here's a yield curve. [yield curve illustrated]

00:34

Note that the ticks on the bottom are time and, on the left--the vertical y-axis there--it's

00:39

percentage, or yield.

00:41

Well, this particular curve slopes oh-so-gently upward. [upward slope demonstrated]

00:44

You can see that bonds maturing in three months yield 2% and bonds maturing in 30 years yield

00:51

4.5%.

00:52

What does this say?

00:53

Well, it says that the debt markets believe that interest rates will be meaningfully higher [diagram explained]

00:58

in the future--like, more than double--and that, to some extent, there's risk in getting

01:02

those bonds paid off.

01:04

That is, money tangibly ready to be paid off in the next two months carries a lot less

01:08

investment risk than bonds three decades away. [roaches discuss bills]

01:11

Yeah, you never know, we could have this... [roaches watch nuclear destruction of world]

01:15

So this is a normal curve: Money near term yields less than money due far away.

01:19

Well, most of the time, this is how yield curves look.

01:22

But think about an era where the government is desperately fighting inflation and it raises [government fights inflation]

01:27

short-term borrowing rates massively. [rates increase]

01:30

Well this, in fact, happened in the 1970s when Vietnam's war economy, coupled with a [Vietnam War footage]

01:35

bunch of other elements, produced roaring inflation in the U.S.

01:38

So the Fed then raised short-term rates into the double digit zone, but most investors [rates increase]

01:44

believed that these very expensive short-term interest rates would stop people from borrowing

01:50

and buying stuff.

01:51

Think about your credit card charging you 25% a year in interest. [big credit card bill]

01:55

Ugh, that's a lot.

01:57

It'll make you think twice about putting that belly button ring set you saw at the mall

02:02

on your AmEx. [person doesn't buy belly button ring]

02:03

So when people stopped buying things on credit, well, they bought a lot less and the economy [tumbleweed in mall]

02:08

cooled, and then the Fed went ahead and lowered rates and the yield curve went back to normal. [rates decrease]

02:14

But for a while, the curve was inverted. [inverted curve demonstrated]

02:18

That is, is started with short-term rates very high, and then long-term rates were cheaper.

02:24

And as you might be able to guess, somewhere in the middle there, as the curves crossed

02:28

over, there was a short period where the yield curve was pretty flat. [flat yield curve demonstrated]

02:32

That is, the price of renting money is the same whether you're borrowing it for three

02:37

months or 30 years.

02:38

You know, that same 3.5% kind of rent.

02:40

Got it?

02:41

So now you've got curves, and you know how to use 'em. [pig admires curves]

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