What A Record Steep Yield Curve Means For Consumers

There are certain elements of economic analysis that elude or bore many consumers. One of them is the yield curve. But the yield curve is pretty easy to understand and it’s very important for how consumer credit—like credit cards, car loans, mortgages, etc.—is priced. A yield curve is a simple line graph plotting short to long term rates. If short rates are roughly the same as long rates, the yield curve will appear flat, and this usually means there is a lot of uncertainty in the economy. If short rates are significantly lower than long rates, the yield curve will be steep, and this usually means the economy is improving.

There are many iterations of yield curves to plot many different short-to-long cost-of-money relationships but the record steep curve that’s been cited is the relationship between 2yr and 10yr Treasury note yields. Most consumer rates aren’t tied directly to Treasury yields but since these securities are so widely traded, they do provide a good representation of broad economic expectations. And again, a steep yield curve like this Treasury curve contains expectations of an improving economy.

Since yields are rates, a steep yield curve means that a consumer could get a lower rate for a shorter term loan than they could for a longer term loan. The easiest example here is a mortgage. With the yield curve as steep as it is now, a mortgage quote for a shorter term loan such as an ARM fixed for 5 years would be significantly lower than a rate for a 30 year fixed.

Right now, the 5yr fixed term would carry a rate about .875% lower than a 30yr fixed term. On a $400,000 loan, the 5yr rate would save $292 per month in interest cost versus the 30yr rate. This spread is so wide because of the currently steep yield curve.

The way to make decisions on which loan is appropriate shouldn’t be from the spread but rather a consumer needs to peg the fixed term of their loan to their expected time horizon in the home. For example, if a couple is buying a home they intend to raise their children in, and they’re on a very tight budget where $292/mo is a big difference, they still shouldn’t take the lower 5yr rate. They should take the 30yr rate. The reason is that they’d still be in the home when the 5yr rate adjusts to current market levels.

Then we come back to the yield curve to project what market levels might look like. The yield curve is steep right now because of expectations that the economy will improve which eventually will cause inflation. Bonds don’t like inflation so to minimize long-term inflation risk investors sell long-dated debt (10yr notes) which pushes those yields up, and buy short-dated debt (2yr notes) which pushes those yields down.

But this phenomenon reverses as the economy improves to a point at which it will level off or contract again. So as we move through economic cycles, the shape of the yield curve—and as such, consumer cost of credit—changes. So in the end, choosing rate structure for things like mortgages or other consumer loans is just like choosing any other investment. It has to be pegged off of expected time horizons for holding that debt. Because like in the mortgage example above, a rate that’s .875% lower for a shorter fixed term can sound very appealing. But that can be problematic as the yield curve changes shape over that initial fixed term.