Flat Yield Curve

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Blog Author :

WallStreetMojo Team

Edited by :

Ashish Kumar Srivastav

Reviewed by :

Dheeraj Vaidya, CFA, FRM

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Flat Yield Curve Meaning

A flat yield curve is a type of yield curve attained on occasions where the yields of different maturities show the same value or are close to one another. There are no interest rate differentials between bonds at the short and long ends of the flat curve, thus indicating uncertainty.

Flat Yield Curve

When the yield curve is flat, it shows the near-zero interest rate sensitivity to the terms to maturity for bonds with the same or similar credit ratings. The yields on long-term and short-term bonds are nearly equal in the flat yield curve, giving the impression that it is almost a straight line.

Table of contents
  • A flat yield curve means that the yields of different maturities exhibit the same value or are relatively close to one another.
  • A flattening curve indicates that investors are losing faith in the economy's prospects for growth and anticipate rate increases in the near future and a decrease in the long term. Therefore, we can say that the flat yield curve and recession are related.
  • Investors pay close attention to the yield curve's shape because it influences the value of other assets and bank returns and predicts how the economy will perform.

Flat Yield Curve Explained

A flat yield curve is one of the most common types of yield curve. A yield curve is a diagram, graph, or table of numbers that display the yield on bonds with the same credit risk but various maturities. It describes the link between the yield on short-term bonds, sometimes referred to as the short end of the yield, and long-term bonds, also known as the long end of the yield.

A yield curve is a tool that one may use to understand bond markets better, interest rates, and the state of the country's overall economy. With a yield curve, one can quickly compare and visualize the yields that investors receive from short-term and long-term bonds, most notably U.S. Treasuries, which are the benchmark for the rest of the economy. When investors buy securities, they are essentially lending money to the government. In return, the Treasury guarantees they will receive their major investment back at maturity along with a specified interest rate on loan (referred to as the coupon).

Bond yield curves offer easy-to-understand depictions of bond markets at one particular time. Bonds, typically as short, medium, or long maturity average yields of bonds from the data of a given day or week. Investors can use a yield curve to determine whether a longer-term bond offers enough yield to offset the higher risk of long-term bond investments compared to shorter-term bonds. The greater the gap in yield and the steeper the curve, the more likely an investor will be ready to take on that risk. Investors receive lower returns and are less likely to invest in long-term bonds as the curve flattens relative to short-term bonds. 

Humped Yield Curve

A flat yield curve is produced when the yields for short-term and longer-term maturities are nearly equal. Amid flat yield curves, there is often a raised region where the mid-term maturities have a greater yield than either the short-term or long-term maturities. The yield curve looks like a hump and is referred to as a humped yield curve. When the curve flattens, it means that the optimism about the economy in the future is deteriorating. A yield curve that is flat or humped may be a sign that the curve may eventually become inverted. Inverted yield curves indicate a recession or bear market, which may not always be the case.

Example

Let us understand the concept with the help of some suitable examples.

Example#1

Dan, an investor, wishes to lend to earn interest. However, recent economic activity has been strong, and the Federal Reserve has raised short-term interest rates. As a result, the yield curve appeared flat, indicating an impending recession. Dan can divide his money to either invest half or lend half in such a situation. Or invest in securities with a longer lock-in period to see how things play out. Of course, one needs to do this cautiously, considering the duration and long-term interest rates. 

Example#2

The 10 year yields of the US Treasury bonds saw a fall from the peak rate which touched a 16- year high, resulting in flattening of the yield curve. This is because investors put a halt to selling off bonds, I order to understand the current rate levels and act accordingly. Not only the 10-year bonds, the ones with different maturity periods also showed similar shape of their yield curve.  

However, this flattening is not for the long term, It is a temporary situation because the US market, which is the world’s largest economy, is showing a sign of betterment and an upside potential after the fall since the COVID situation. Therefore, there is a good chance of the yield curve to improve very soon.

Uses

Generally, the interest rate is usually high when money is lent for a longer duration, as the lender will not receive the amount during that long gap. In contrast, shorter-term loans carry less interest. In addition, a flat yield curve means that those having money to lend are willing to accept the same interest rate for short-term loans as they would for long-term loans.

Historically, inverted or flat yield curves and recession are correlated. A flat yield curve means that those with the ability to lend are concerned that their money will have less chance of earning high interest in the future and decide to lend the money now to secure a higher rate for a longer period. Fewer people borrowing money means less economic activity; less borrowing means less demand. This is why many view flattening curves as an indicator of recession in the future. However, other factors may contribute to such an economic situation. These include short-term rates affected by the Federal Reserve while market forces impact long-term rates. When short-term rates rise, the cost of borrowing for customers also increases. In addition, U.S. banks typically boost their benchmark rates for a variety of consumer and business loans, such as credit cards and small business loans. Additionally, mortgage rates also rise.

With a steepening yield curve, banks usually borrow money at lower rates while lend at greater rates. Conversely, when the curve is flatter, they experience tighter margins, which could discourage lending. such an artificial increase in short-term rates by the Fed can affect the yield curve frequently and even start to flatten it. A flattening yield curve may eventually be the outcome of Federal Reserve policies. As a result, investors may think that a recession is about to start. Hence, precaution is needed while predicting.

Implications

A flat yield curve shows that the spread between the yield of long term and the short term bonds is reducing or very less. Therefore it has an effect on the investment decisions of bondholders.

  • If the investors see that they will not earn any extra compensation for holding bonds on a long term basis. They will earn almost same return as short term bonds. This will lead to reduction of long term investments. The demand for short term bonds will increase because now they can earn same amount with less risk.
  • The yield curve turning flat also implies that the participants of the financial market are expecting that inflation is about to reduce or the Federal Reserve has the possibility of deciding on increasing on raising fund rates in the coming future. The Fed raises the interest rates to control inflation since higher rates curtail the money supply and lower prices, demand and investments. Since rise in interest leads to rise in yields, the spread between short and long term bond yield will increase, making the yield curve steep.
  • The yield curve which is flat also implies that investors do not have strong faith on market performance. They are of the opinion that their investments will not give much return, which in turn may lead to lower investment, bringing down liquidity and money supply in the economy.

Thus, the above are some important effects or implications in the financial market due to a yield curve that is flat.

Frequently Asked Questions (FAQs)

1. Why does the yield curve flatten?

The flattening of the yield curve happens as a result of long-term interest rates falling compared to short-term interest rates. Or when short-term interest rates rise as opposed to long-term interest rates.

2. What does a flat yield curve indicate?

The yield spreads between long-term, and short-term bonds are said to be narrowing if the yield curve is flattening. Therefore, it could serve as a warning before making long-term investments because it signals market instability. Additionally, such a curve is used by economists and analysts as a predictor of upcoming recessions.

3. Why is a flat yield curve bad?

Flattening yield curves are bad because they indicate upcoming recession, ongoing economic instability, and uncertainty. Investors tend to lose faith in economic growth under such situations.

4. Why is the flat yield curve bad for banks?

Banks can borrow cash at lower rates and lend it at higher rates when the yield curve steepens. If the curve is flatter, on the other hand, they experience squeezed margins, which could discourage lending.