What Is a Yield Curve?
Let me explain to you what a yield curve is: it's a line that plots the yields or interest rates of bonds with the same credit quality but different maturity dates. The slope of this curve can predict where interest rates are heading and whether the economy might expand or contract. You can find these yield curve rates published daily on the United States Department of the Treasury’s website after each trading day.
Key Takeaways
Yield curves simply plot the interest rates of bonds over time. In general, you should expect higher yields or interest rates in the long run when risk is at its peak. A normal curve points toward economic expansion, while a downward-sloping one suggests a recession might be coming.
How a Yield Curve Works
A yield curve acts as a benchmark for other debts in the market, like mortgage rates or bank lending rates. It can help predict changes in economic output and growth. The most commonly reported one compares U.S. Treasury debt for three-month, two-year, five-year, 10-year, and 30-year terms. These rates are available on the Treasury's website by 6:00 p.m. ET each trading day. Some investors use the yield curve to decide on investments based on where bond rates might go. You can easily build a visual of the curve in an Excel spreadsheet if you want to see it for yourself.
Types of Yield Curves
There are three main types of yield curves: normal, inverted, and flat. I'll break them down for you one by one.
Normal Yield Curve
A normal yield curve shows low yields for shorter-maturity bonds that increase as maturities get longer, creating an upward slope. This setup indicates that yields on longer-term bonds are rising in response to economic expansion. It implies stable economic conditions and a normal cycle. If the curve is steep, it suggests strong growth, often with higher inflation and interest rates. For example, you might see a two-year bond at 1%, a five-year at 1.8%, a 10-year at 2.5%, a 15-year at 3.0%, and a 20-year at 3.5%. Some investors use a roll-down return strategy, selling bonds as they near maturity—also called riding the curve. This works in stable rates where the bond's yield falls and price rises, letting you capture profits from the price increase.
Inverted Yield Curve
An inverted yield curve slopes downward, with short-term interest rates higher than long-term ones. This corresponds to economic recession periods, where investors expect longer-maturity bond yields to drop in the future. In downturns, investors prefer longer-dated bonds for safety, bidding up their prices and driving down yields. This type is rare and has historically warned of recessions.
Flat Yield Curve
A flat yield curve has similar yields across all maturities, signaling economic uncertainty. There might be a slight hump in intermediate maturities, like six months to two years, with marginally higher yields. For instance, a two-year bond at 6%, five-year at 6.1%, 10-year at 6%, and 20-year at 6.05%. In high uncertainty, investors demand similar yields no matter the maturity.
What Is a U.S. Treasury Yield Curve?
The U.S. Treasury yield curve is a line chart comparing yields of short-term Treasury bills to long-term notes and bonds. It shows the relationship between interest rates and maturities of these securities. It's also known as the term structure of interest rates.
What Is Yield Curve Risk?
Yield curve risk is the potential adverse impact from interest rate shifts on fixed-income returns, like bonds. It comes from the inverse relationship between bond prices and interest rates: prices drop when rates rise, and vice versa, in the secondary market.
How Can Investors Use the Yield Curve?
You can use the yield curve to predict economic changes that influence your investment choices. If it indicates a slowdown, shift to defensive assets that perform well in recessions. If it's steep, suggesting inflation, avoid long-term bonds whose yields could erode against rising prices.
The Bottom Line
Yield curves come in three shapes: normal upward-sloping, inverted downward-sloping, and flat. The slope predicts interest rate changes and economic activity. Use it to make investment decisions based on the economy's likely near-term direction.
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