A:

The yield curve is a graphed line that represents the relationship between short- and long-term interest rates, specifically in government securities. Examining the yield curve serves a number of purposes for market analysts, but its primary importance is as a predictor of recessions.
The yield curve plots the yields to maturity and the times to maturity for U.S. Treasury bills, notes and bonds, thus showing the various yields from the shortest-term treasuries - Treasury bills - to the longest-term treasuries - the 30-year Treasury bond. The resulting line is usually asymptotic - that is, it initially curves upward but then flattens out the farther the line extends. Short-term interest rates are determined by the federal funds rate that the Federal Reserve sets, but long-term interest rates are largely determined by the market. Looking at points further out on the yield curve reveals the current market consensus on the likely future direction of both interest rates and the economy.

The usual upsloping yield curve line indicates that investors and analysts expect economic growth and inflation - and thus rising interest rates - in the future. Also, it's natural for Treasurys that take much longer to mature to carry a higher interest rate since there's greater risk involved with holding an investment asset over a long period of time. The higher interest rate normally commanded by Treasury bonds reflects what is called a risk premium.

If there is a departure from the normal situation where longer-term interest rates are higher than shorter-term rates, if short-term interest rates move up to a point where they are higher than long-term rates, then the yield curve becomes downsloping, or inverted. Market analysts consider an inverted yield curve to be a very strong indication of a coming recession and possible deflation. In the latter half of the 19th century and into the early 20th century, before the creation of the Federal Reserve Bank, it was normal for the yield curve to be inverted because there were frequent periods of deflation and virtually no extended time periods of inflation.

Generally, an upsloping yield curve is taken as indicating the likelihood that the Federal Reserve will raise interest rates in an attempt to curb inflation. A downsloping, inverted yield curve is commonly interpreted to mean that the Federal Reserve will most likely make significant interest rate cuts in order to stimulate the economy and prevent deflation. A flat yield curve, neither upsloping nor downsloping, indicates that the market consensus is that the Federal Reserve may be cutting interest rates somewhat to stimulate the economy but, unless there are further indications of possible deflation, it will not cut rates aggressively.

Economists, market analysts and investors in bonds or other fixed income investments monitor the yield curve closely because significant interest rate changes, affecting financing costs and therefore expenditure decisions of businesses across all market sectors, are a major factor in driving the market and the economy as a whole.

RELATED FAQS
  1. What is the difference between yield and return?

    Return is the financial gain or loss on an investment. Yield measures the income, such as interest and dividends, from an ... Read Answer >>
  2. What is the difference between yield to maturity and the yield to call?

    Determining various the various yields that callable bonds can provide investors is an important factor in the bond purchasing ... Read Answer >>
Related Articles
  1. Investing

    Bond yield curve holds predictive powers

    This measure can shed light on future economic activity, inflation levels and interest rates.
  2. Insights

    U.S. Recession Without a Yield Curve Warning?

    The inverted yield curve has correctly predicted past recessions in the U.S. economy. However, that prediction model may fail in the current scenario.
  3. Insights

    Is a Recession in the Works? Ask an Inverted Yield Curve

    An inverted yield curve has predicted the last seven recessions. Is number eight around the corner?
  4. Insights

    Is a Recession Coming? Watch the Yield Curve

    The yield curve can be an indicator of which way the economy is heading.
  5. Investing

    Charles Schwab: Flattening Yield Curve Isn't Reason to Worry About Stocks

    While stock investors have plenty of worries, the flattening yield curve shouldn't be one of them, says Charles Schwab's Liz Ann Sonders.
  6. Investing

    How Bond Market Pricing Works

    Want to know how bond price are determined? Learn the basic rule of the bond market.
  7. Investing

    The Importance Of U.S. Treasury Rates

    U.S. Treasury bond interest rates affect more than just bondholders! It impacts the day to day lives of all consumers.
  8. Investing

    How Rising Interest Rates and Inflation Affect Bonds

    Understand bonds better with these four basic factors.
  9. Investing

    Why Surging Bond Yields Won’t Kill the Bull Market

    Yields are rising for all the right reasons and that is a positive for earnings and stock prices.
  10. Financial Advisor

    Top 4 Treasurys ETFs (SHY, IEI)

    Learn about the specifics of the top four U.S. Treasury ETFs and how investors can buy ETFs that invest in bonds along the yield curve.
RELATED TERMS
  1. Inverted Yield Curve

    An inverted yield curve is the interest rate environment in which ...
  2. Yield Curve

    A yield curve is a line that plots the interest rates, at a set ...
  3. Curve Steepener Trade

    Curve steepener trade is a strategy that uses derivatives to ...
  4. Bull Flattener

    A bull flattener is a yield-rate environment in which long-term ...
  5. Bear Steepener

    A bear steepener is the widening of the yield curve caused by ...
  6. Negative Butterfly

    A negative butterfly is a non-parallel yield curve shift in which ...
Hot Definitions
  1. Current Assets

    Current assets is a balance sheet account that represents the value of all assets that can reasonably expected to be converted ...
  2. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  3. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  4. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
  5. Depreciation

    Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account ...
  6. Ratio Analysis

    A ratio analysis is a quantitative analysis of information contained in a company’s financial statements.
Trading Center