Flat Yield Curve

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Definition of Flat Yield Curve:

A flat yield curve describes the yield curve when there is little difference between short-term and long-term interest rates for debts with the same default risk. 

Detailed Explanation:

A yield curve can be drawn for any debt instrument with varying maturities, but of similar default risk. Mortgages, CDs, corporate bonds, and municipal bonds are several securities that have yield curves. However, when investors speak of the yield curve, they are referring to the market for US government Treasuries. The US Department of the Treasury publishes daily yield curve rates.

When graphing a yield curve, the vertical axis is the yield to maturity and the horizontal axis is the time until maturity. Normally investors demand a higher return for longer-term investments of similar default risk. But occasionally short-term rates may exceed long-term rates. The yield curve flattens when transitioning between a normal and inverted yield curve, or vice versa. 

What causes the yield curve to flatten? The Federal Open Market Committee controls the short-term rates directly when it changes the federal funds or discount rates. However, the investors in the debt markets have a greater influence on the long-term end of the yield curve. The changing slope of the yield curve depends on the relative changes between short-term and long-term rates. 

  • Begin with a normal yield curve, and the economy is nearing the peak of a business cycle. The FOMC may choose to increase the federal funds rate, which raises the short-term interest rates. Meanwhile, long-term investors expect the FOMC’s action will reduce inflation by reducing economic growth. They may choose to purchase longer-term bonds to lock in rates for a longer period. 

  • Begin with an inverted yield curve, and an economy that is in a recession. The FOMC may reduce the federal funds rate as part of its expansionary monetary policy. Meanwhile long-term investors may anticipate entering the growth phase of a new business cycle within a few years, raise price levels and demand a larger interest premium. 

  • A flight to quality may reduce long-term rates relative to short-term rates. A flight to quality occurs when an economic event stokes fear that other investments will perform poorly. Investors seeking safety increase the demand for long-term treasuries, thereby driving up the price and reducing long-term rates.  

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