How Does Inflation Affect the Yield Curve?
The yield curve has long been viewed as an economic indicator. A steepening curve usually signals a strong economy. But it can also be a sign that higher inflation is on the horizon.
Investors may know the yield curve as a visual depiction of yields and bond maturities. At its most simple, the curve reflects yield differences among bonds of the same credit quality but different maturity dates.
But the slope of the yield curve can provide insight about where the market and the economy may be headed. That’s how it may help savvy investors make smarter decisions about their portfolios.
Understanding the relationship between the yield curve and the economy can help you choose suitable investments for your short- and long-term goals. Knowing how the yield curve relates to inflation might also help you prepare for rising costs and adjust your portfolio accordingly.
How to Read the Yield Curve
“Yield curve” can refer to any pattern plotted for a variety of bonds. Many investors look to the U.S. Treasury yield curve for clues about the direction of the economy. It compares yields of short-, intermediate- and long-maturity bonds.
A normal yield curve is upward sloping, reflecting the steady increase in yields as bond maturities extend. That’s because investors expect higher yields when they take on the risks of longer-maturity bonds. (Those risks might include default and inflation, for example, although Treasuries have historically had a very low potential for default.) The yield curve typically takes on an upward slope when the economy is growing.
Investors may be more willing to favor stocks over bonds during a strong economy. That’s when potential stock gains are likely to be more than they’d get from bonds.
But when the curve is flattening or becomes inverted (downward sloping), shorter-maturity bonds have equal or even higher yields than longer-maturity securities. That’s usually an indication of a weakening economy or recession.
In this situation, the defensive characteristics of bonds may become more attractive to investors.
Inflation’s Effect on the Yield Curve
A normal, upwardly sloping yield curve is typically a sign of a strong economy. But a steep curve also may signal higher inflation. Stronger economic growth often leads to price increases.
In periods of economic growth, longer-term bond investors seek higher yields to justify keeping their money in the bond market for longer periods. In response, bond issuers offer higher yields to compensate for the higher costs that generally unfold over time.
The Bottom Line
Investors usually interpret a steepening yield curve as a sign of a growing economy. But higher inflation typically accompanies an expanding economy. Therefore, it makes sense that longer-maturity bonds would offer higher yields—to compensate for rising costs over time.
When the yield curve steepens, it may be a good idea to make sure your investment strategy is designed to outpace inflation.
Generally, as interest rates rise, the value of the securities held in the fund will decline. The opposite is true when interest rates decline.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.