Flat Yield Curve

What Is the Flat Yield Curve?

The flat yield curve is a yield curve in which there is little difference between short-term and long-term rates for bonds of the same credit quality. This type of yield curve flattening is often seen during transitions between normal and inverted curves. The difference between a flat yield curve and a normal yield curve is that a normal yield curve slopes upward.

Understanding the Flat Yield Curve

When short and long-term bonds offer equivalent yields, there is usually little benefit in holding the longer-term instrument; the investor does not gain any excess compensation for the risks associated with holding longer-term securities. If the yield curve is flattening, it indicates the yield spread between long-term and short-term bonds is decreasing. For example, a flat yield curve on U.S. Treasury bonds is one in which the yield on a two-year bond is 5% and the yield on a 30-year bond is 5.1%.

A flattening yield curve may be a result of long-term interest rates falling more than short-term interest rates or short-term rates increasing more than long-term rates. A flat yield curve is typically an indication that investors and traders are worried about the macroeconomic outlook. One reason the yield curve may flatten is market participants may be expecting inflation to decrease or the Federal Reserve to raise the federal funds rate in the near 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.

Special Consideration: The Barbell Strategy

The barbell strategy may benefit investors in a flattening yield curve environment or if the Federal Reserve is looking to raise the federal funds rate. However, the barbell strategy may underperform when the yield curve steepens. The barbell strategy is an investment strategy that could be used in fixed-income investing and trading. In a barbell strategy, half of a portfolio is comprised of long-term bonds, while the rest is comprised of short-term bonds.

For example, assume the yield spread is 8%, and an investor believes the yield curve will flatten. The investor could allocate half of the fixed-income portfolio to U.S. Treasury 10-year notes and the other half to U.S. Treasury two-year notes. Therefore, the investor has some flexibility and could react to changes in the bond markets. However, the portfolio may experience a significant fall if there is a meteoric increase in long-term rates, which is due to the duration of long-term bonds.