Ahhh yes, the fascinating world of the Flat Yeild Curve, The Saskatchewan of all Yeild Curves, what could possibly be more interesting? OK, almost anything, but I’m going to talk about it anyway.
So just what is a Flat Yield Curve?
The term sounds like an oxymoron much like the expressions, pretty ugly, old news, or small crowd. In the simplest of terms a Flat Yield Curve occurs when there is very little difference between short-term and long-term bond rates with similar credit qualitys.
So let’s unpack that to better understand what a Flat Yield Curve is. When short and long-term bonds offer similar yields, under these circumstances there is no extra compensation for the additional risk an investor takes by holding long-term bonds, which turns it into a risk versus reward conversation. If the yield curve is flattening, it indicates the yield spread between long-term and short-term bonds is decreasing.
A flattening yield curve may be a result of long-term interest rates falling more than short-term interest. One reason the yield curve may flatten is market participants may be expecting inflation to decrease or the Federal Reserve to raise rates in the short term.
For example, if the Federal Reserve increases its short-term target over a specified period, long-term interest rates may remain stable or rise. However, short-term interest rates would rise. Consequently, the slope of the yield curve would flatten as short-term rates increase more than long-term rates.
So what do we know:
- A flattening yield curve is when short-term and long-terms bonds see no discernible change in rates.This in turn makes long-term bonds less attractive to investors.
- This non-curve, curve can be a psychological marker, which may signal that investors are losing faith in a long-term market's growth potential.
There are various strategies to combat a flattening yield curve. One of those is by employing what is called a Barbell strategy, which simply put, is balancing The fixed income portion of a portfolio between long-term and short-term bonds. It works even better if you’re able to stagger the bond maturities. However, although the barbell strategy may benefit investors in a flattening yield curve environment, it may underperform when the yield curve steepens.
As with all investment strategies, you want to be careful that you’re not overreacting and in turn over correcting due to day-to-day market fluctuations whether your investing in equities or bonds. Taking a long term balanced approach will usually win the day.