Why should an MLO or borrower care about the yield curve? Let’s start with some basics.
The curve (e.g., a graph) represents interest rates on Treasury debt for a range of maturities, showing the yield an investor expects to earn if they lend their money for a given period of time. The curve is a diagram of leading economic indicators, in that its changing shape occurs at different points in the economic cycle. It is typically upward sloping, reflecting higher long-term returns (e.g., 30-year bonds) than short-term returns (e.g., overnight fed funds, or a 3-month yield) since investors expect more compensation for lending their money for a longer period of time due to the greater risk.
The yield curve flattens or eventually inverts when the perception of long-term investors that interest rates will decline in the future causes shorter-term debt to be more attractive by comparison, which usually dovetails with the expectation of a decline in inflation and portends an economic downturn. It is important to pay attention to because the shape of the curve helps investors get a future sense of the course of interest rates. Since investors will generally prefer the lower risk of short-term maturity securities over long-term maturity securities, the price of short-term securities will be higher, and the corresponding yield lower. Typically, the more robust the economy, the steeper the slope.
In 2020, when the Federal Reserve decreased the overnight Federal Funds rate (the rate banks charge each other) to near 0 percent, the slope of the yield curve increased. But starting in April of 2022 through May of 2023, it dropped dramatically and went negative (an inverted yield curve) leading many to state that a recession was on the way. Lately long-term rates have been declining, but short-term have been declining even more, suggesting that the yield curve may recapture it’s normal, upwardly sloping, shape with few signs of a recession on the horizon.
For a fine pictorial chart of yield curve trends, the Federal Reserve of St. Louis comes through for us!