If you invest in stocks, you should keep an eye on the bond market. If you invest in real estate, you should keep an eye on the bond market. If you invest in bonds or bond ETFs, you definitely should keep an eye on the bond market.

The bond market is a great predictor of inflation and the direction of the economy, both of which directly affect the prices of everything from stocks and real estate to household appliances and food.

A basic understanding of short-term vs. long-term interest rates and the yield curve can help you make a broad range of financial and investing decisions.

Interest Rates and Bond Yields

The terms interest rates and bond yields are sometimes used interchangeably but there is a difference.

An interest rate is the percentage that must be paid to borrow money. You pay interest to borrow money and earn interest to lend money when you invest in a bond or save money in a CD.

Key Takeaways

  • A normal yield curve shows bond yields increasing steadily with the length of time until they mature, but flattening a little for the longest terms.
  • A steep yield curve doesn't flatten out at the end. This suggests a growing economy and, possibly, higher inflation to come.
  • A flat yield curve shows little difference in yields from the shortest-term bonds to the longest-term. This indicates uncertainty.
  • The rare inverted yield curve signals trouble ahead. Short-term bonds pay better than longer-term bonds.

Most bonds have an interest rate that determines their coupon payments, but the true cost of borrowing or investing in bonds is determined by their current yields.

A bond's yield is the discount rate that can be used to make the present value of all of a bond's cash flows equal to its price. A bond's price is the sum of the present value of all cash flow that will ever be received from the investment.

The return from a bond is commonly measured as yield to maturity (YTM). That's the total annualized return that the investor will receive assuming that the bond is held until it matures and the coupon payments are reinvested.

YTM thus provides a standard annualized measure of return for a particular bond.

Short-Term vs. Long-Term

Bonds come with a variety of maturity periods from as little as one month to 30 years. Normally, the longer the term is the better the interest rate should be. So, when speaking of interest rates (or yields), it is important to understand that there are short-term interest rates, long-term interest rates, and many points in between.

While all interest rates are correlated, they don't always move in step. Short-term rates might fall while long-term interest rates might rise, or vice versa.

Understanding the current relationships between long-term and short-term interest rates (and all points in between) will help you make educated investment decisions.

Short-Term Interest Rates

The benchmarks for short-term interest rates are set by each nation's central bank. In the U.S., the Federal Reserve Board's Open Market Committee (FOMC) sets the federal funds rate, the benchmark for all other short-term interest rates.

The FOMC raises or lowers the fed funds rate periodically in order to encourage or discourage borrowing by businesses and consumers. Its goal is to keep the economy on an even keel, not too hot and not too cold.

Borrowing activity overall has a direct effect on the economy. If the FOMC finds that economic activity is slowing, it might lower the fed funds rate to increase borrowing and stimulate the economy. However, it is also concerned with inflation. If it holds short-term interest rates too low for too long, it risks igniting inflation.

The FOMC's mandate is to promote economic growth through low-interest rates while containing inflation. Balancing those goals is not easy.

Long-Term Interest Rates

Long-term interest rates are determined by market forces. Primarily these forces are at work in the bond market.

If the bond market senses that the federal funds rate is too low, expectations of future inflation will rise. Long-term interest rates will go up to compensate for the perceived loss of purchasing power associated with the future cash flow of a bond or a loan.

On the other hand, if the market believes that the federal funds rate is too high, the opposite happens. Long-term interest rates decrease because the market believes interest rates will go down in the future.

Reading the Yield Curve

The term "yield curve" refers to the yields of U.S.Treasury bills, notes, and bonds in order, from shortest maturity to the longest maturity. The yield curve describes the shapes of the term structures of interest rates and their respective times to maturity in years.

The curve can be displayed graphically, with the time to maturity located on the x-axis and the yield to maturity located on the y-axis of the graph.

For example, treasury.gov displayed the following yield curve for U.S. Treasury securities on Dec. 11. 2015:

Yield Curve for U.S. Treasury Securities

The above yield curve shows that yields are lower for shorter maturity bonds and increase steadily as bonds become more mature.

The shorter the maturity, the more closely we can expect yields to move in lock-step with the fed funds rate. Looking at points farther out on the yield curve gives a better sense of the market consensus about future economic activity and interest rates.

Below is an example of the yield curve from January 2008.

U.S. Treasuries

Bills Maturity Date Discount/Yield Discount/Yield Change
3-Month 04/03/2008 3.12/3.20 0.03/-0.027
6-Month 07/03/2008 3.10/3.21 0.06/-0.074
Notes/Bonds Coupon Maturity Date Current Price/Yield Price/Yield Change
2-Year 3.250 12/31/2009 101-011/2 / 2.70 0-06+/-0.107
5-Year 3.625 12/31/2012 102-04+ /3.15 0-143/4 / 0.100
10-Year 4.250 11/15/2017 103-08 / 3.85 0-111/2/ -0.044
30-Year 5.000 5/15/2037 110-20 / 4.35 0-051/2 / -0.010

Figure 1: Yield Curve January 2008

Source: Bloomberg.com

The slope of the yield curve tells us how the bond market expects short-term interest rates to move in the future, based on bond traders' expectations about economic activity and inflation.

This yield curve is "inverted on the short-end." That suggests that the traders expect short-term interest rates to move lower over the next two years. They're expecting a slowdown in the U.S. economy.

The yield curve is best used to get a sense of the economy's direction, not to try to make an exact prediction.

Types of Yield Curves

There are several distinct formations of yield curves: normal (with a "steep" variation), inverted, and flat. All are shown in the graph below.

A Normal Yield Curve

As the orange line in the graph above indicates, a normal yield curve starts with low yields for lower maturity bonds and then increases for bonds with higher maturity. A normal yield curve slopes upwards. Once bonds reach the highest maturities, the yield flattens and remains consistent.

This is the most common type of yield curve. Longer maturity bonds usually have a higher yield to maturity than shorter-term bonds.

For example, assume a two-year bond offers a yield of 1%, a five-year bond offers a yield of 1.8%, a 10-year bond offers a yield of 2.5%, a 15-year bond offers a yield of 3.0%, and a 20-year bond offers a yield of 3.5%. When these points are connected on a graph, they exhibit a shape of a normal yield curve.

Such a yield curve implies stable economic conditions and should prevail throughout a normal economic cycle.

Steep Yield Curve

The blue line in the graph shows a steep yield curve. It is shaped like a normal yield curve with two major differences. First, the higher maturity yields don’t flatten out at the right but continue to rise. Second, the yields are usually higher compared to the normal curve across all maturities.

Such a curve implies a growing economy moving towards a positive upturn. Such conditions are accompanied by higher inflation, which often results in higher interest rates.

Lenders tend to demand high yields, which get reflected by the steep yield curve. Longer-duration bonds become risky, so the expected yields are higher.

Flat Yield Curve

A flat yield curve, also called a humped yield curve, shows similar yields across all maturities. A few intermediate maturities may have slightly higher yields, which causes a slight hump to appear along the flat curve. These humps are usually for the mid-term maturities, six months to two years.

As the word flat suggests, there is little difference in yield to maturity among shorter and longer-term bonds. A two-year bond could offer a yield of 6%, a five-year bond 6.1%, a 10-year bond 6%, and a 20-year bond 6.05%.

Such a flat or humped yield curve implies an uncertain economic situation. It may come at the end of a high economic growth period that is leading to inflation and fears of a slowdown. It might appear at times when the central bank is expected to increase interest rates.

In times of high uncertainty, investors demand similar yields across all maturities.

Inverted Yield Curve

The shape of the inverted yield curve, shown on the yellow line, is opposite to that of a normal yield curve. It slopes downward.

An inverted yield curve means that short-term interest rates exceed long-term rates.

A two-year bond might offer a yield of 5%, a five-year bond a yield of 4.5%, a 10-year bond a yield of 4%, and a 15-year bond a yield of 3.5%.

An inverted yield curve is rare but is strongly suggestive of a severe economic slowdown. Historically, the impact of an inverted yield curve has been to warn that a recession is coming.

Historical Yield Curve Accuracy

Yield curves change shape as the economic situation evolves, based on developments in many macroeconomic factors like interest rates, inflation, industrial output, GDP figures, and the balance of trade. 

While the yield curve shouldn't be used to predict exact interest rate numbers and yields, closely tracking its changes helps investors to anticipate and benefit from short- to mid-term changes in the economy.

Normal curves exist for long durations, while an inverted yield curve is rare and may not show up for decades. Yield curves that change to flat and steep shapes are more frequent and have reliably preceded the expected economic cycles.

For example, the October 2007 yield curve flattened out, and a global recession followed. In late 2008, the curve became steep, which accurately indicated a growth phase of the economy following the Fed’s easing of the money supply.

Using the Yield Curve to Invest

Interpreting the slope of the yield curve is useful in making top-down investment decisions. for a variety of investments.

If you invest in stocks and the yield curve says to expect an economic slowdown over the next couple of years, you might consider moving your money to companies that perform well in slow economic times, such as consumer staples. If the yield curve says that interest rates should increase over the next couple of years, investment in cyclical companies such as luxury-goods makers and entertainment companies makes sense.

Real estate investors can also use the yield curve. While a slowdown in economic activity might have negative effects on current real estate prices, a dramatic steepening of the yield curve, indicating an expectation of inflation, might be interpreted to mean prices will increase in the near future.

Of course, it's also relevant to fixed-income investors in bonds, preferred stocks, or CDs. When the yield curve is becoming steep—signaling high growth and high inflation–savvy investors tend to short long-term bonds. They don't want to be locked into a return whose value will erode with rising prices. Instead, they buy short-term securities.

If the yield curve is flattening, it raises fears of high inflation and recession. Smart investors tend to take short positions in short-term securities and exchange-traded funds (ETFs) and go long on long-term securities.

You could even use the slope of the yield curve to help decide if it's time to purchase a new car. If economic activity slows, new car sales are likely to slow and manufacturers might increase their rebates and other sales incentives.