Image Source: Unsplash

We haven’t had a normalized yield curve in the bond market since 2008. It looks like it’s finally going back to normal, which is a good thing for the stock market.

What is a normalized yield curve?

Now, what is “normalized” you may ask? That’s a good question! A yield curve is represented on a graph. The horizontal axis represents time and the vertical axis represents price (or yield). A normal curve rises from lower left (less time, lower yields) to upper right (more time, higher yields). The thinking goes that you should be compensated more for lending money for a longer period of time. Makes sense, doesn’t it?

Below is what a normalized yield curve looks like.

But we have had a flat or inverted yield curve, which goes back about 15 years to the Global Financial Crisis of 2008-09. The effects from that disastrous economic period had long tentacles and thus took a very long time to play out. Given the circumstances, reserve banks around the globe reduce borrowing rates to zero or in some cases (Europe), even lower for a large stretch of time.

The bond market really took it on the chin

Through it all, the stock market bounced back, but it was the bond market that really felt the twists and turns. As a result of a zero interest rate policy, the yield curve (term structure) flattened considerably. Our Federal Reserve was determined to let rates stay low for as long as it took to take a potential depression off the table. Once removed, the Federal Open Market Committee could slowly bring up rates and hopefully create a more normalized curve.

This situation has not been bad for the stock market. In fact, the stock market has been on an historic run to new highs even as the yield curve has been abnormal. Since 2022, higher interest rates and elevated inflation inverted the term structure.

More recently, the Federal Reserve has cut rates in an effort to release the economy from very tight monetary conditions, which may spur more growth, consumer buying, and lending. These are all bonuses for the stock market.

More By This Author: