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How to Understand the Yield Curve

The Federal Reserve has signaled that interest rates will eventually rise. It may be tempting to conclude that, with diligence and perseverance, you could uncover a way to profit from this knowledge. If you find yourself enticed by this possibility, the question you need to ask is, “What do I know about what the Fed will do that the market doesn’t?” If you’re being completely truthful, you will answer, “Nothing.”

The beauty of the market is that it already incorporates all of our collective expectations about the Fed’s likely future actions in the current yield curve. What is the yield curve? It is a visual depiction of the interest rates at various maturity dates for bonds of the same credit quality. The curve can be upward or downward sloping. (Historically, an inverted yield curve has predicted an economic slowdown.) Unless you’re positive that you are smarter than the market, the yield curve is your best guide for what interest rates will be in the future.

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