Yield Curve

Reading the curve

Every day, the market puts a price on lending money to the Government of Canada for different lengths of time. Plot those yields against their terms, from the 3-month treasury bill through the 2-year, 5-year, 10-year and 30-year bond, connect the dots, and you have the yield curve.

It looks like a modest technical chart, but it is one of the most watched pictures in finance, because it condenses the market's collective expectations about growth, inflation and future interest rates into a single line.

What sets each end

The two ends of the curve answer to different masters. The short end, bills and bonds maturing within a year or two, hugs the Bank of Canada policy rate: paper that matures soon can only pay roughly what the central bank is paying now, adjusted for where markets think the next few decisions will land.

The long end, 10 years and beyond, belongs to expectations. A 30-year yield is mostly a bet on average inflation and economic growth over decades, plus compensation for tying money up that long. The central bank influences it only indirectly, through how credible its inflation control looks.

The three shapes

The curve spends its life shifting between three basic shapes:

• Normal (upward sloping): long yields sit above short yields. Lenders demand extra yield, a term premium, to lock money away longer and shoulder more inflation risk. This is the curve's default posture in a calm economy.
• Flat: short and long yields nearly match. Markets expect the policy rate to drift down toward long-run levels, often a transition phase between the other two shapes.
• Inverted: short yields sit above long yields. Markets expect meaningful rate cuts ahead, usually because they expect the economy to weaken.

The mortgage connection

The curve is the hidden pricing engine of the Canadian mortgage market. A fixed-rate mortgage is priced off the Government of Canada bond yield of the matching term: the popular 5-year fixed tracks the 5-year GoC yield, plus a spread for the lender's costs, risk and margin. A variable-rate mortgage instead follows the prime rate, which moves in step with the policy rate at the short end.

So the two mortgage types live at different points on the curve, and the curve's shape decides which one looks cheaper on a given day. With a normal upward slope, variable rates start below fixed rates, which is the pattern most borrowers assume is permanent. When the curve inverts, the logic flips: 5-year yields fall below short rates, and fixed mortgage rates can drop below variable rates. Borrowers who "know" that variable is always the cheaper start are often surprised to find the fixed sticker lower; the curve explains why.

Inversion: the famous recession signal

An inverted curve has a reputation as the bond market's recession warning, and the reputation is earned: inversions have preceded most modern recessions in Canada and the United States. The logic is simple. Short rates are high because the central bank is squeezing; long rates are lower because investors expect that squeeze to slow the economy and force cuts.

The honest caveats matter as much as the signal. The lag between inversion and any downturn has ranged from a few months to a couple of years, the depth of inversion says little about the depth of what follows, and the signal has fired without a recession arriving. An inverted curve is a barometer worth respecting, not a countdown clock.

What it means for savers

GIC rate boards are a retail photocopy of the curve. Banks fund themselves along the same maturities, so when the curve is normal, a 5-year GIC pays more than a 1-year. When the curve inverts, the board flips too, and a 1-year GIC can out-yield the 5-year. That inverted menu is tempting, but it carries reinvestment risk: when the short GIC matures, the high short rates that made it attractive may be gone. Locking a slightly lower long rate, or laddering across terms, is often the sturdier answer.