A yield curve is a line that plots the yields or interest rates of bonds that have equal credit quality but different maturity dates. The slope of the yield curve predicts the direction of interest rates and the economic expansion or contraction that could result.
Yield curves have three main shapes: normal upward-sloping, inverted downward-sloping, and flat. Yield curve rates are published on the U.S. Department of the Treasury’s website each trading day.
Key Takeaways
Yield curves plot the interest rates of bonds of equal credit and different maturities.
Normal curves point to economic expansion.
Downward-sloping curves point to economic recession.
Yield curve rates are published on the U.S. Department of the Treasury’s website each trading day.
Using a Yield Curve
A yield curve is a benchmark for other debts in the market such as mortgage rates and bank lending rates. The yield curve can predict changes in economic output and growth over time.
The most frequently reported yield curve compares the three-month, two-year, five-year, 10-year, and 30-year U.S. Treasury debt. Yield curve rates are available on the Treasury's interest rate websites by 6:00 p.m. ET each trading day.
Some investors use the yield curve to make investment decisions based on the likely direction of bond rates. A visual representation of the curve is easy to build using an Excel spreadsheet.
Types of Yield Curves
The three types of yield curves include normal, inverted, and flat.
Normal Yield Curve
A normal yield curve shows low yields for shorter-maturity bonds increasing for bonds with a longer maturity. The curve slopes upward. This indicates that yields on longer-term bonds continue to rise, responding to periods of economic expansion.
A normal yield curve implies stable economic conditions and a normaleconomic cycle. A steep yield curve implies strong economic growth with conditions often accompanied by higher inflation and higher interest rates.
Sample yields on the curve can include a two-year bond that offers a yield of 1%, a five-year bond that offers a yield of 1.8%, a 10-year bond that offers a yield of 2.5%, a 15-year bond offers a yield of 3.0%, and a 20-year bond that offers a yield of 3.5%.
Some bond investors will use a roll-down return strategy and sell a bond as it moves toward its maturity date. This strategy is also known as riding the curve. It works in a stable rate environment as the bond's yield falls and the price rises. Investors hope to capture profit from the rise in bond prices.
Inverted Yield Curve
An inverted yield curve slopes downward with short-term interest rates exceeding long-term rates. This type of curve corresponds to a period of economic recession when investors expect yields on longer-maturity bonds to trend lower in the future.
Investors seeking safe investments in an economic downturn tend to choose longer-dated bonds over short-dated bonds, bidding up the price of longer bonds and driving down their yield.
An inverted yield curve is rare. It's historically been a warning of recession.
Flat Yield Curve
A flat yield curve shows similar yields across all maturities, implying an uncertain economic situation. A few intermediate maturities may have slightly higher yields that cause a slight hump to appear along the flat curve. These humps are usually for mid-term maturities of six months to two years.
The curve shows little difference in yield to maturity among shorter and longer-term bonds. A two-year bond may 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%.
In times of high uncertainty, investors demand similar yields across all maturities.
What Is a U.S. Treasury Yield Curve?
The U.S. Treasury yield curve is a line chart that allows for the comparison of the yields of short-term Treasury bills and the yields of long-term Treasury notes and bonds. The chart shows the relationship between the interest rates and the maturities of U.S. Treasury fixed-income securities.
The Treasury yield curve is also referred to as the term structure of interest rates.
What Is Yield Curve Risk?
Yield curve risk refers to the adverse effect of a shift in interest rates on the returns from fixed-income instruments such as bonds. It stems from the fact that bond prices and interest rates have an inverse relationship to each other. The prices of bonds in the secondary market decrease when market interest rates increase and vice versa.
How Can Investors Use the Yield Curve?
Investors can use the yield curve to make predictions about the economy that will affect their investment decisions.
An investor might move their money into defensive assets that traditionally do well during a recession if the bond yield curve indicates an economic slowdown. They might avoid long-term bonds with a yield that will erode against increased prices if the yield curve becomes steep, suggesting future inflation.
The Bottom Line
Yield curves come in three main shapes: a normal upward-sloping curve, an inverted downward-sloping curve, and a flat curve. The slope of the yield curve predicts interest rate changes and economic activity. Investors can use the yield curve to make investment decisions that factor in the likely direction of the economy in the near future.
What is the yield curve? The yield curve – also called the term structure of interest rates – shows the yield on bonds over different terms to maturity. The 'yield curve' is often used as a shorthand expression for the yield curve for government bonds.
Riding the yield curve is a trading strategy that involves buying a long-term bond and selling it before it matures so as to profit from the declining yield that occurs over the life of a bond. Investors hope to achieve capital gains by employing this strategy.
Yield curves reflect the cost of borrowing money and the rates for savers. The direction of yield curves can hint about the health of the economy. An “inverse” yield curve has been associated with past recessions.
What is the Yield Curve? The Yield Curve is a graphical representation of the interest rates on debt for a range of maturities. It shows the yield an investor is expecting to earn if he lends his money for a given period of time.
A positive, upward-sloping yield curve occurs when yields of shorter maturities are lower than yields of longer maturities. Conversely, an inverted, downward-sloping yield curve forms when yields of shorter maturities are higher than longer maturities.
The rule of thumb is that an inverted yield curve (short rates above long rates) indicates a recession in about a year, and yield curve inversions have preceded each of the last eight recessions (as defined by the NBER).
Note that the yield-curve slope becomes negative before each economic recession since the 1970s. That is, an “inversion” of the yield curve, in which short-maturity interest rates exceed long-maturity rates, is typically associated with a recession in the near future.
In our opinion, the yield curve, first and foremost, predicts the Fed policy cycle rather than the business cycle. Our research confirms this conclusion, as does a recent Fed study. More specifically, inverted yield curves don't cause recessions.
The logic of spread trading is straightforward. If you expect the yield curve to steepen, you typically want to buy the spread.If you expect the yield curve to flatten, you will want to sell the spread. You buy or sell a yield curve spread in terms of what you do on the short maturity leg of the trade.
A normal yield curve shows low yields for shorter-maturity bonds increasing for bonds with a longer maturity. The curve slopes upward. This indicates that yields on longer-term bonds continue to rise, responding to periods of economic expansion.
Therefore, when interest rates change, the yield curve will shift, representing a risk, known as the yield curve risk, to a bond investor. The yield curve risk is associated with either a flattening or steepening of the yield curve, which is a result of changing yields among comparable bonds with different maturities.
See higher-yielding parts of the bond market. The shape of the yield curve also impacts portfolio returns. When the yield curve is inverted, for example, and short-term bonds yield more than long-term bonds, investors can earn a bigger return owning a short-term bond.
The yield curve is a visual representation of how much it costs to borrow money for different periods of time; it shows interest rates on U.S. Treasury debt at different maturities at a given point in time.
A yield curve is a way to measure bond investors' feelings about risk, and can have a tremendous impact on the returns you receive on your investments. People often talk about interest rates as though all rates behave in the same way.
Treasury yields also show how investors assess the economy's prospects. The higher the yields on long-term U.S. Treasuries, the more confidence investors have in the economic outlook. But high long-term yields can also be a sign of rising inflation expectations.
Supporting Economic Growth and Inflation: YCC is a tool to promote borrowing and investment by keeping long-term interest rates low. By lowering the cost of borrowing for businesses and consumers, the BoJ aims to encourage economic expansion and combat deflation.
A yield measures the income that your investment earns (dividends and interest) but it does not take into account capital gain, such as an increase in share price. Even though this income is from a specific period, it gets annualised. That is because a yield assumes this income will continue at the same rate.
A steepening yield curve—that is, one with an increasing spread between long- and short-term rates—usually implies an expectation of higher short-term rates in the future. A flattening curve, on the other hand, implies an expectation of falling short-term rates.
A normal yield curve is considered a positive sign, indicating investor confidence in the economy's growth prospects. It suggests that the market expects a healthy, growing economy with rising interest rates to counteract inflationary pressures.
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