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.