Yield Curve 101

Working at a credit union, you are well aware of how an interest rate can be different for each person based on their credit score. A person with a bad credit score will be expected to pay higher interest rates to try and compensate for the risk of lending to them. And of course, people with the best credit scores get the lowest rates. But have you ever thought that there are other factors that can impact the interest rate?

You know that home loan rates differ from auto rates. And, unsecured loans or personal loans can have very high rates. That is because the type of underlying collateral (or lack thereof) drives the risk of lending too. Another thing you may have not considered is the term of a loan also affects whether a rate will be higher or lower. This is because of uncertainty. If we make a loan for 15 years, we don’t know if someone will continue to have the same ability to pay for all of those 15 years into the future. So, the longer we make a loan for, the more risk we need to price into the interest rate, and generally the interest rate will be higher.

Long-term loans also present a unique risk to the credit union in terms of interest rate risk. If a credit union makes a loan for 15 years, and then interest rates move up, the money in that 15-year loan will be stuck receiving a lower interest rate until the loan pays off.  The credit union then loses out on the chase to make money at a higher interest rate.

This opportunity cost of being stuck with a lower interest rate into the future is something studied heavily in finance. We can actually map out what interest rates look like from today, if we make a short-term loan or a long-term loan. This graph is typically referred to as the Yield Curve. And as you might expect, the longer the interest is fixed for, the higher the rate usually is. Below, you will see a graph I have made using interest rates from 2005, 2007 and 2016.


As you can see, the interest rates for all of 2016 have pretty much followed a similar pattern. The line on the very top of the 2016 bundle is actually our current yield curve for the end of October 2016. The yield curve for May 2005 (when I graduated college) has a similar shape, but is notably adjusted considerably higher than current rates. So overall, in the past 11 years, rates have come down considerably. And lastly, the 2007 yield curve actually slopes downwards. Why is that?!

What is particularly fascinating about the yield curve is that it can be a predictor for the economy too. If investors suspect a recession is about to occur, they expect the Fed will lower rates, thus we will see lower rates in the future. This will cause the yield curve to actually slope downwards or flatten out. Clearly, in 2007, investors expected a recession, which surely followed in 2008.

You can likely assume the opposite is true, which is when the yield curve slopes upwards, investors are more optimistic about the future and are expecting the Fed to potentially raise rates in the future. And what is notable about October 2016 is the yield curve has a stronger upward slope than the immediately preceding months in 2016. Perhaps this is because the economy is showing more strength, and a Fed rate hike is becoming more likely.