What’s a flat yield curve?
The flat yield curve occurs when short-term and long-term rates for bonds of the same credit rating are similar. This yield curve flattening occurs during normal-inverted curve transitions. Standard yield curves slope upward, unlike flat ones.
Understanding Flat Yield Curve
Long-term bonds give no extra return for higher risks when short-term and long-term rates differ. The yield spread between long-term and short-term bonds decreases when the yield curve flattens. A flat yield curve on U.S. Treasury bonds is characterized by a 5% yield on two-year notes and a 5.1% yield on 30-year bonds.
The yield curve may flatten if long-term interest rates decrease more than short-term rates or vice versa. A flat yield curve usually indicates macroeconomic concerns among investors and traders. Market players may anticipate inflation to fall or the Fed to hike the federal funds rate, flattening the yield curve.
If the Federal Reserve raises its short-term objective over time, long-term interest rates may rise or stay the same. Short-term interest rates would climb. Therefore, the yield curve slope would flatten when short-term rates rose more than long-term rates.
Special Note: Barbell Strategy
The barbell approach may benefit investors if the yield curve flattens or the Federal Reserve plans to raise the federal funds rate. The barbell approach may underperform as the yield curve steepens. Fixed-income investors and traders can adopt the barbell approach. A barbell approach invests half in long-term bonds and half in short-term bonds.
If the yield spread is 8%, an investor expects the yield curve to flatten. The investor might split the fixed-income portfolio between 10-year and 2-year U.S. Treasury notes. Thus, the investor can adapt to bond market developments. Due to the tenure of long-term bonds, the portfolio may plummet if long-term rates rise rapidly.
Conclusion
- The yield curve flattens when short-term and long-term bonds have similar yields. Investors find long-term bonds less appealing.
- A psychological indication like this curve may indicate investors are losing trust in a long-term market’s development potential.
- Barbelling a portfolio between long-term and short-term bonds can help resist a flattening yield curve. This method works best with “laddered,” or staggered, bonds.
