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Finance, a la Shmoop. [title page]

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What's the difference between normal, inverted, and flat yield curves, and what to they tell

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us?

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All right, well let's start with the basics.

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Yield curve... ooh, sexy term. [guy talks about yield curves]

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Say it a lot and people will think you know a lot about finance.... or that you're really [people are pretty impressed]

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into slowing down while making gradual left turns. [pig thanks slow driver]

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But in finance, a yield curve is just a graphic representation of bond yields, from "maturing [yield curves defined]

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soon" to "not maturing for a really long time."

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So here's a yield curve. [yield curve illustrated]

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Note that the ticks on the bottom are time and, on the left--the vertical y-axis there--it's

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percentage, or yield.

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Well, this particular curve slopes oh-so-gently upward. [upward slope demonstrated]

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You can see that bonds maturing in three months yield 2% and bonds maturing in 30 years yield

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4.5%.

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What does this say?

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Well, it says that the debt markets believe that interest rates will be meaningfully higher [diagram explained]

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in the future--like, more than double--and that, to some extent, there's risk in getting

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those bonds paid off.

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That is, money tangibly ready to be paid off in the next two months carries a lot less

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investment risk than bonds three decades away. [roaches discuss bills]

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Yeah, you never know, we could have this... [roaches watch nuclear destruction of world]

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So this is a normal curve: Money near term yields less than money due far away.

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Well, most of the time, this is how yield curves look.

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But think about an era where the government is desperately fighting inflation and it raises [government fights inflation]

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short-term borrowing rates massively. [rates increase]

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Well this, in fact, happened in the 1970s when Vietnam's war economy, coupled with a [Vietnam War footage]

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bunch of other elements, produced roaring inflation in the U.S.

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So the Fed then raised short-term rates into the double digit zone, but most investors [rates increase]

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believed that these very expensive short-term interest rates would stop people from borrowing

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and buying stuff.

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Think about your credit card charging you 25% a year in interest. [big credit card bill]

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Ugh, that's a lot.

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It'll make you think twice about putting that belly button ring set you saw at the mall

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on your AmEx. [person doesn't buy belly button ring]

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So when people stopped buying things on credit, well, they bought a lot less and the economy [tumbleweed in mall]

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cooled, and then the Fed went ahead and lowered rates and the yield curve went back to normal. [rates decrease]

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But for a while, the curve was inverted. [inverted curve demonstrated]

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That is, is started with short-term rates very high, and then long-term rates were cheaper.

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And as you might be able to guess, somewhere in the middle there, as the curves crossed

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over, there was a short period where the yield curve was pretty flat. [flat yield curve demonstrated]

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That is, the price of renting money is the same whether you're borrowing it for three

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months or 30 years.

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You know, that same 3.5% kind of rent.

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Got it?

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So now you've got curves, and you know how to use 'em. [pig admires curves]

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