(Wow, the spam filters are going to have a field day with this one!)

We left off on our juicy interest rate discussion (c’mon…you know you love to read about scintillating, fascinating, yummy-delicious interest rates…gets the blood pumping!) 🙂 with some bond basics: yield, price, and coupon value, and why 10-year notes are the “new” benchmark for economic health and so interesting to sophisticated investors.

And now that we know what yield is, it’s time to talk about…the yield curve!

Luckily, that’s easy…it’s simply a measure of the difference between the interest rate on short-term notes and the interest rate on long-term bonds.

“Typically”, under what we like to call “normal” economic circumstances, when things are going along swimmingly, rates on short-term notes are usually less than the rates on long-term bonds. This is because there is less risk that the bond issuer (the borrower) won’t be able to make his payments for the next three months than there is that he won’t be able to make his payments for the next ten years.

(Apparently most people and countries can somehow scrape together enough cash to make payments for three months, but it’s much more difficult to commit to paying consistently over ten years, and hence a higher risk of bankruptcy or failure to pay).

Also, longer-term bonds have “inflation risk”, which is the risk that inflation will increase at a higher rate than the interest rate, eating into your profits (if you are the bond-buyer) over the long-term. For example, if you buy a 30-year bond that pays 3%, but inflation begins to skyrocket in year 10, your interest payments from year 11 – year 30 will feel much smaller and will buy you much less stuff due to inflation (less purchasing power).

So, for those reasons, long-term bonds “usually” have higher interest rates than short-term bonds, and if you plot these rates on a chart (as finance nerds just love to do….no offense to any finance nerds out there, I’m one too!) you have what is called a “yield curve”:

Yield Curve

More or less "normal" yield curve; Chart courtesy of StockCharts.com

You can see the maturity of the notes on the “x-axis” (haven’t used that term in awhile…that would be the “horizontal-axis” for those of you who long ago have forgotten your algebra, like me), and the yield on the “y-axis” (yep, the vertical one).

This is considered a more or less “normal” yield curve, because it slopes up and to the right.

Economists and sophisticated investors love to read all kinds of things into this curve…how steep it is, whether or not it is “flattening” or not, and God forbid if it is “inverting”!

What is an “inverted” yield curve?

An inverted yield curve is when the line slopes the other way…down and to the right. (Are you sensing the Viagra reference yet?) 🙂 What this means is that short-term interest rates are actually higher than long-term interest rates, and this has been known to fairly consistently predict an economic recession.

Yes, the last time this happened was in 2007, and we all know what happened next…

And the yield curve also inverted in 2000, right before the U.S. equity markets collapsed (of course, yours truly had never even heard of a yield curve then….smart money I was not!).

In fact, since 1970, this “inverting of the yield curve” has accurately predicted every single recession (except for one false positive in 1998!).

So this is a new “smart money” tool for you…rather than listening to all of the talking heads on CNBC, you can now simply go to this Dynamic Yield Curve link at StockCharts.com and see for yourself what is happening in the economy!

By the way, Stock Charts is an awesome site, and their dynamic yield curve chart is the best I have found. It is animated and shows the direct relationship between the yield curve and the S&P 500. You can click on the S&P 500 over any period of time (say, late 2006 – 2007) and see exactly when the yield curve began to invert (and correspondingly when the S&P 500 subsequently fell off a cliff).

It is crucial to learn about these “smart money” tools and to think for yourself when investing, rather than just listening to the talking heads or what the mainstream news media is “telling you” these charts mean!

It is highly instructive to go back in time and read the newspaper articles around some of these recessions…here’s one from Monday, March 19, 2007, titled appropriately, “The Inverted Yield Curve – Is It Really Different This Time?”. (Um, no…).

When you are able to understand and read these tools for yourself, and to think for yourself, then you will truly be in the “smart money” leagues. Every day we all take one step closer!

I have barely scratched the surface with the yield curve, but am already over 1000 words so will have to carry on with interest rate manipulation and how the Fed “manages” the long-term end of the curve for another day.

“But Kung Fu Girl, what on earth does this have to do with Viagra???”

I’m so glad you asked….to my warped little mind, the simplest way to remember economic “happy times” and economic “sad times” is to imagine a man standing on the vertical-axis….when the “line” slopes up, good times are to be had, and when the “line” slopes down…possibly some Viagra (or QE…) is in store. (So sorry… I never said this was a “PC” blog!)

But I bet you will remember this now… Have a great week, and see you on Friday!

To your financial success,
— Kung Fu Girl