A yield curve is a graphical presentation of the yield of bonds or securities of the same credit quality at various maturity levels. And these yield curves are of two types, Flat and Steep. A Flat Yield Curve, as the word suggests, is a relatively flat curve of a yield. It implies that there is very little difference between the short and long-term interest rates. Or, we can say it is essentially a horizontal line showing similar interest rates of short and long-term debt securities of the same quality. Such a curve also conveys that there is a minimum difference between the short and long-term interest rates of a bond or security.
For example, a bond with a maturity of 20-year will have the same yield that of a five-year bond of the same credit quality.
Flat Yield Curve – What it Means for Investor, Market, and Lenders?
For an investor, a flat yield curve means there is no immediate benefit to investing in a bond with higher maturity. Or, there is no incentive for investors to invest in long-term securities or for the lender to lend for a longer duration. So, the investors see it as an opportunity to invest now, than to hold money for future investment.
For the market, a flat yield curve indicates some sort of uncertainty and thus, should act as a red flag for making long-term investments. Also, economists and analysts use such a curve as an indicator of a potential recession.
Any lender or investor would want the interest on long-term investments to compensate them for the effect of inflation, time, and credit risk. However, a flat yield curve may suggest that the market is expecting lower inflation in the future. This means with a flat yield curve; investors are not much concerned about the impact of inflation on their investment.
Reasons for Flat Yield Curve
The reasons for such a curve could be:
- It occurs when the expected interest rates are stable.
- Such occurrence is also possible when the short-term volatility is more than the long-term volatility.
- When the long-term interest rates drop more than the short-term rates.
- Or, the short-term rates rise more than the long-term rates.
Federal Reserve policies may also result in such a curve. Usually, the Federal Reserve comes up with monetary policies to tackle some economic issues or as and when they feel there is a need. As part of the monetary policy, the Fed can change the overnight rate, which would encourage other financial institutions to change their interest rates.
Such a change in the interest rates may impact the yield curve as well, and it may start to get flat. Some investors may see it as a warning sign of a recession. But, this was a result of Fed policy that may or may not lead to recession. Still, it is better for investors to remain cautious when the yield curve starts to flatten, for whatever reason.
How it is Different from the Normal, Inverted, and Steep Yield Curve?
We generally see a flattening curve when an economy shifts from a normal to an inverted state. A normal yield curve slopes upward and, as the word suggests, shows normal behavior. It slopes upward from left to right, suggesting a rise in yield with an increase in the duration to compensate for the longer-duration investment risks.
We usually see an inverted yield curve before the recession. Such a curve means the short-term bonds offer more return to the investors than the long-term securities. Though this is an inverse of a normal scenario, it is logical.
When there is low economic growth, investors go for long-term assets to ensure the safety of their funds. As more and more investors go for long-term assets, this results in more demand and, eventually, a drop in the yield. A drop in yield, in turn, signifies slower economic growth.
The steep yield curve is the opposite of the flat yield curve. Or, in this situation, the difference between the short and long-term yields is the maximum. We usually see such a curve at the start of the economic expansion or at the end of the recession.
Generally, whenever there is a steep yield curve, the short-term interest rates remain very low. The Central bank would have reduced them to tackle the recession. A steep yield curve suggests that investors expect inflation to rise and economic growth to pick up.
What do Investors Need to Do?
In the situation when the short and long terms interest rates are similar, it becomes very confusing for investors to choose their investment strategy. One tested strategy in such a scenario is the barbell strategy. This strategy is useful for investing in fixed-income instruments and trading. The strategy is very simple and effective. It suggests that the investor should invest half of its portfolio in long-term bonds and the remaining portfolio in short-term bonds.
For example, if an investor expects the curve to get flat, then he may allocate half of the funds to a 20-year bond and another half to a 2-year bond. Such a portfolio would allow investors to react quickly to market changes.
However, the barbell strategy could result in losses at the time of a steep yield curve. Or when there is a significant rise or drop in the long-term interest rates.
In all, we can say that a flat yield curve is not good for an efficient market. Such a curve discourages investors from making long-term investments as they don’t see any real gain. Thus, it results in reducing long-term investments and pushes investors towards short-term bonds.