Key Takeaways
A yield curve is a chart that shows the interest rates (yields) on bonds with different maturity dates.
The four main types of yield curves include normal, inverted, flat, and steep curves, each signaling different economic expectations.
Yield curve steepening happens when the difference (spread) between short-term and long-term bond yields grows over time.
The yield curve can influence both crypto and stock markets, but is particularly relevant to interest-sensitive sectors like banking, real estate, and utilities.
What Is a Yield Curve?
A yield curve is a chart that shows the interest rates (or yields) on bonds with different maturity dates. We can think of the yield curve as a line that compares short-term interest rates to long-term ones, typically for US Treasury bonds.
Bond yields vary by maturity because investors demand different rates of return depending on the bond's duration, often due to inflation expectations, credit risks, and general economic conditions.
As such, the shape of the yield curve tells us a lot about what investors are expecting from the economy, offering a kind of financial weather forecast. The US Treasury Yield Curve is the most famous and often acts as a barometer for economic health, influencing decisions across various markets.
Types of Yield Curves
There are four main types of yield curves based on their shapes. Each yield curve type can tell investors about different economic conditions, making them useful indicators for what might be coming.
The examples below are for illustrative purposes only, so don’t worry too much about the values. Focus on the different curve shapes and their typical interpretation.
Normal yield curve
This curve slopes upward, meaning long-term bonds have higher yields than short-term ones. It suggests that investors are expecting stable economic growth. When the curve is normal, long-term bonds may offer good returns, and the stable outlook is favorable for stocks, cryptocurrencies, and other growth-focused investments.
Inverted yield curve
The inverted yield curve slopes downward, with short-term yields higher than long-term yields. Historically, this has been a warning sign for recession. This shape can be a caution sign for stock investors, who might consider rebalancing portfolios towards safer assets like bonds.
Flat yield curve
The flat yield curve has little to no slope, with short-term and long-term yields being very similar. It can mean economic uncertainty or a transition phase. A flat curve suggests uncertainty, prompting investors to stay cautious with diversified investments across assets.
Steep yield curve
The steep yield curve forms when long-term yields rise sharply above short-term ones, often pointing to expected economic growth and rising inflation. When the yield curve is steep, it’s often a green light for investing in riskier assets, like crypto and stocks, as a steep curve generally signals positive growth prospects.
Yield Curve Steepening
Yield curve steepening happens when the difference (or spread) between short-term and long-term bond yields grows. It describes the shifts that occur in the yield curve over time (e.g. when comparing the yield curves of two different years).
Types of yield curve steepening
There are different types of yield curve steepening, but the two main types are known as the bull steepening and the bear steepening.
Bull steepening: When short-term bond yields drop more than long-term yields. This can happen when central banks cut short-term interest rates to stimulate the economy, but longer-term rates stay steady, reflecting growth expectations. The green dashed line represents the yield curve after the changes.
Bear Steepening: In this case, long-term yields rise faster than short-term ones, often because investors expect stronger economic growth or higher inflation in the future. The red dashed line represents the yield curve after the changes.
How to Use the Yield Curve in Financial Markets
The yield curve can be a useful tool for predicting changes in interest rates, which can impact a wide range of assets. For example, when the curve inverts, the US Federal Reserve and other central banks may lower interest rates to prevent an economic slowdown, often giving markets a short-term boost. Traders and investors may use these rate shifts as opportunities to enter or exit certain markets and adjust bond holdings.
Bond market
Since the yield curve directly involves bond yields, any changes can cause bond prices to swing. Rising interest rates (often linked to an upward-sloping yield curve) generally cause existing bonds to lose value since new bonds will have higher yields. Conversely, if rates drop, older bonds with higher rates become more valuable.
Stock market
The yield curve can influence all kinds of stocks, especially in interest-sensitive sectors like banking, real estate, and utilities. For example, if the yield curve inverts, indicating a possible economic slowdown, investors may pull back from stocks and seek safer investments. Alternatively, a steep yield curve can signal strong economic growth, which can boost confidence in the stock market.
Interest rates
The variation in yields is often used as a benchmark for mortgage rates, bank lending rates, and other types of debt. When the yield curve inverts, it usually acts as a prompt for the Fed to lower interest rates to stimulate the economy, which can impact borrowing costs for consumers and businesses.
Yield Curve and Cryptocurrency Markets
While the yield curve is mainly associated with traditional markets, it’s beginning to intersect with crypto in some interesting ways, especially as crypto-assets become more integrated with institutional investments.
There is an increasing number of investors and money managers who now include bitcoin and other cryptocurrencies as part of their portfolios.
While it’s true that the increased adoption led crypto markets to behave somewhat similar to stocks, some investors see bitcoin as a form of digital gold – especially when traditional markets face uncertainty. For instance, if the yield curve inverts and recession fears rise, some investors may choose to increase their exposure to assets like gold and bitcoin, which historically have been great “store of value” assets.
In addition, central bank decisions to lower rates in response to the yield curve often increase liquidity in the financial system, which may flow to crypto markets. This added liquidity can boost demand for cryptocurrencies, potentially pushing prices higher.
While the yield curve can give crypto investors insight, it doesn’t work exactly the same way as with traditional assets. Cryptocurrencies are still highly speculative and can be influenced by many other factors, including regulatory news and technological developments. So, while the yield curve may offer context, experienced crypto investors often rely on a broader set of indicators.
Closing Thoughts
Whether you’re into traditional investments or just exploring cryptocurrency, the yield curve is a powerful tool to have on your radar. Not only does it offer hints about the direction of the economy, but it also helps investors plan their strategies across asset classes.
Further Reading
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