The Yield Curve and Investor Sentiment (Part II)

In the last section I talked about what a normal yield curve is and what it usually looks like. However, the yield curve will change over time and these changes can be very important indications for what investors think about the market today and what they expect in the future. In this section we will look at the four main types of yield curves and how today's curve differs from the credit crisis of July, 2007.

A yield curve can be inverted, flat, normal or steep. Inverted or flat yield curves are bearish while normal and steep curves are considered bullish.

Inverted Yield Curve
An inverted yield curve means that investors are being paid more for short term debt than long term debt. That is extremely bearish because it means that investors are expecting yields to drop significantly in the long term and that short term risk is high as well. An inverted yield curve has a striking correlation to bear equity markets.

Flat Yield Curve
A flat yield curve is also bearish for the same reasons an inverted curve is negative. A flat curve indicates a lack of investor confidence in the future. The last credit crisis in July of 2007 was correlated with a flat yield curve and followed an inverted curve earlier that year. This is one of the reasons why the correction in the stock market was so severe since last year.

Normal Yield Curve
A normal yield curve indicates lower short term yields and a mild increase between mid-term and long-term debt. This is a very common scenario and indicates a normal level of confidence about the future.

Steep Yield Curve
A steep yield curve is very bullish as traders expect better yields in the future. A steep yield curve means that longer term yields are much higher than short and mid-term yields. This type of curve is correlated with rallies in the stock market.

Currently there is a steep yield curve in the market and this is one of the most significant differences between today's market and conditions in July of 2007. While there is definitely still risk in the market, it is not the same kind of risk as it was in 2007.

Are you an investor in fixed income? What do you think about the future of bonds?

Comments

[adan:]

really like the basic info, hope it continues in complexity

gotta recommend my favorite bond site right now: across the curve
acrossthecurve.com/

also has great info in varying detail

thanks!

2008 Aug 27 09:00 AM

[Nidhi Kadalbal:]

The link below shows how stock markets have responded to variations in bond yields ...

creating-wealth.blogsp...

2008 Aug 27 09:41 AM

[je:]

Where does normal begin and end?

Where does steep begin?

2008 Aug 27 03:18 PM

[dieuwer:]

The yield curve has been contracting since mid March. There is a danger of inverting.

2008 Aug 27 07:28 PM