Yield curve

What is a yield curve?

The yield curve is a graphical representation of interest rates or yields for bonds with similar credit quality but varying maturity dates. It provides valuable insights into future interest rate movements and economic activity. Let’s explore the three primary shapes of the yield curve: the normal upward-sloping curve, the inverted downward-sloping curve, and the flat curve.

Types of yield curves

Normal yield curve

A normal yield curve, characterized by an upward slope, typically reflects economic growth and expansion. It showcases lower yields for bonds with shorter maturities and progressively higher yields for longer-term bonds. This positive slope signifies investor expectations of higher yields in the future.

During periods of economic expansion, the Federal Reserve, as the central bank, carefully monitors the yield curve and adjusts interest rates accordingly. The bond market reacts to these changes, influencing bond prices and yields. Higher yields are generally associated with increased demand for long-term bonds from investors seeking higher returns.

Conversely, in an economic downturn, the yield curve may flatten or even invert, indicating lower yields or an inverted yield curve. Inverted yield curves occur when short-term yields surpass long-term yields, which can be a concerning sign for market participants. It suggests investor expectations of economic stagnation or a potential recession.

Inverted yield curve

An inverted yield curve depicts a downward slope, indicating a situation where short-term interest rates surpass long-term rates. This inversion, known as a yield curve inversion, is often associated with economic slowdowns and can signify impending recession. During this period, investors expect yields on longer-maturity bonds to decrease in the future.

In response to an economic downturn, investors seeking safer investments tend to shift their focus towards longer-dated bonds, resulting in higher demand for these fixed-income securities. The increased demand drives up the price of longer-term bonds, consequently pushing down their yields. This phenomenon is particularly evident in the humped yield curve, where certain maturities experience slightly higher yields than others.

It’s important to note that the yield curve slopes represent the varying yields across different maturities. When the yield curve steepens, the gap between short-term and long-term yields widens, indicating expectations of increasing yields in the future. On the other hand, when the yield curve flattens, the difference between short-term and long-term yields decreases, suggesting a more stable interest rate environment.

Flat yield curve

A flat yield curve indicates that yields are relatively similar across various maturities, signaling an uncertain economic environment. Within the flat curve, yields may be slight variations, leading to small humps. Typically, these humps occur for mid-term maturities, ranging from six months to two years.

The flat yield curve demonstrates minimal differences in yield to maturity between shorter-term and longer-term bonds. For example, a two-year bond might offer a yield of 6%, a five-year bond of 6.1%, a 10-year bond of 6%, and a 20-year bond of 6.05%. During periods of heightened uncertainty, investors seek comparable yields across different maturities, reflecting their cautious stance.

Normal yield curve and inverted yield curve

An inverted yield curve occurs when longer-term bonds exhibit lower yields than short-term debt instruments. This represents an atypical situation in the bond market. In contrast, a normal yield curve is characterized by short-term debt instruments offering lower yields than long-term debt instruments with the same credit quality.

How is a yield curve used?

A yield curve serves as a reference point for various forms of debt in the market, including mortgage rates and bank lending rates, while also offering insights into potential shifts in economic performance and expansion.

Among the commonly referenced yield curves, the comparison typically includes the three-month, two-year, five-year, 10-year, and 30-year U.S. Treasury debt. These yield curve rates are readily accessible through the Treasury’s interest rate websites and are updated by 6:00 p.m. ET at the end of each trading day.

How to read an interest rate curve?

The yield curve exhibits two primary movements: upward and downward.

In a normal yield curve, there is an upward slope, indicating that the interest rate on shorter-dated bonds is lower compared to longer-dated bonds. This upward slope compensates investors holding long-term bonds for the time value of money and potential default risks associated with the bond issuer.

Alternatively, a yield curve with higher rates on longer-dated bonds is often referred to as a steepening yield curve. This term describes the situation where yields increase over time. When visualized on a chart, the line depicting the yield curve moves from the lower left to the upper right, illustrating the progressively higher interest rates.