While the yield curve is, of course, a product of the bond market, this does not mean that its usefulness is confined to bond investors alone. Indeed, given the broad array of events that the yield curve has forecasted, it behooves all investors, including equity investors, to put the yield curve in their tool box.
Before I go on, let me give you a little primer on the yield curve.
The yield curve is basically a chart that plots the yields on bonds carrying different maturities, usually ranging from three months to 30 years. It looks something like this:
A Normally Positive Slope When bond investors analyze the yield curve to try to glean its meaning, they look at the difference between yields on short-term securities compared with that of long-term securities. The spread between the two-year note and 30-year bonds is commonly used.
A "normal" yield curve is one in which long-term maturities have higher yields than short-term maturities. In such a case, the yield curve is deemed to have a positive slope. The curve is considered inverted when long-term maturities have a lower yield than short-term ones.
The shape of the yield curve can mean a variety of things to bond investors but there are two basic ways of looking at it.
First, if it is "positively sloped," this is usually an indication that the Federal Reserve's monetary policy stance is and will likely continue to be friendly toward the markets. That is why the yield on short-term maturities is lower longer maturities (the Fed controls short-term interest rates). A friendly Fed is usually good news to stocks and to the economy. So a steepening yield curve generally means good times for investors over several quarters.
On the other hand, a "negatively sloped" yield curve usually indicates that Fed policy is unfriendly, with the Fed engaged in a strategy to slow the economy by raising short-term interest rates. This, of course, generally portends a gloomier set of conditions for the equity market, as well as the economy
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