Interest rates and inflation are closely linked phenomena. As we discussed last week, expectations about inflation can provide insights to the direction of our overall economy. The yield curve is another place where the market interest rates reveal a sense of what the market expects with regard to inflation and future economic conditions.
The yield curve is simply the structure of market interest rates for instruments (treasury bills or corporate bonds) with varying maturity dates. Ordinarily, the yield curve is expected to slope upwards: that is, as maturity length on a financial instrument increases, the yield on that instrument increases as well, reflecting the normal expectation that investors have to receive a higher yield to commit to longer-maturing investments. In addition to the higher real interest and risk premiums associated with longer-maturing investments, expectations about inflation are embedded in the relationship between time to maturity and yield.
A steep yield curve (longer term rates are much higher than shorter term rates) can suggest the market expects higher inflation, economic growth, and/or volatility. A flatter curve (little difference between short and long term rates) can signal lower inflation expectations and more stability. Sometimes the yield curve inverts or slopes downward, with yields declining as maturity increases. An inverted yield curve signals expectations of deflation and is a fairly reliable indicator of an impending recession.
Figure 1 shows the yield curve for Treasury bills/notes with maturities from one month to 10 years for the last day of April 2022 compared yield curves from February 2020 and November 2007.
Figure 1. Treasury Yield by Maturity: Selected Daily Yields, 2007 to 2022
Clearly, in the recessionary environments of 2007 and 2020, the yield on long-maturity instruments was much lower relative to short-maturity instruments than would generally be expected.
Recent changes in the shape of the yield curve trace out the development of inflation expectations in the post pandemic period. Figure 2 shows the daily yield curve in two-month intervals beginning with the last trading day in August 2021.
Figure 2. Treasury Yield by Maturity: Selected Daily Yields, 2021 to 2022
Not only have rates increased since last summer, but the slope of the yield curve has changed. For maturities ranging from 1-month to 2-years, the curve has grown considerably more steep as of June 2022, likely indicating expecations of a continued struggle with inflation in the near term. However, for maturities over the range of 1-year to 10-years, the curve has become flatter (compare October 2021 with June 2022). The yield curve has not inverted as, for example, in 2007, which would suggest strong expectations of an imminent recession. However, the longer term portion of the curve becoming flatter suggests an outlook of at least a slowdown in the economy that eventually gets inflation under control.