What Is the Current Yield Curve?
The current yield curve shows the relationship between short- and long-term interest rates in government securities. Market analysts examine the yield curve and track it over time for a number of reasons. Most importantly, it is seen as a predictor of the likelihood of a recession.
Understanding the Current Yield Curve
The key to understanding the current yield curve is the fact that the interest rates on short-term government securities are determined by the Federal Reserve while the interest rates on long-term government securities are largely determined by the market.
- The current yield curve shows all U.S.-issued securities and their rates of return.
- An upward curve suggests that investors expect healthy economic growth.
- A downward curve is seen as a warning of a recession ahead.
Thus, interest rates on long-term government securities are seen as reflecting the sentiment of the market.
What the Yield Curve Shows
The yield curve plots the yields to maturity and the times to maturity for U.S. Treasury bills, notes, and bonds. That shows the various yields offered for all of these securities, from the shortest-term Treasury bills to the 30-year Treasury bond.
The line shown 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 interest rates in particular and the economy in general.
Up, Down, or Flat?
The usual upsloping yield curve line indicates that investors and analysts expect economic growth and inflation, and therefore 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.
In normal times, long-term bonds pay higher rates than short-term bonds because the investor is locking up money for a longer period of time.
That's considered normal. If there is a departure from the normal, and short-term interest rates are higher than long-term rates, then the yield curve becomes downsloping.
That downsloping line is the infamous inverted yield curve.
What an Inverted Yield Curve Means
Market analysts consider an inverted yield curve to be a very strong indication of a coming recession and even deflation. In the latter half of the 19th century and into the earliest years of the 20th century, before the creation of the Federal Reserve Bank, it was normal for the yield curve to be inverted. There were frequent periods of deflation and virtually no extended 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 is likely to make significant interest rate cuts in order to stimulate the economy and prevent deflation. A flat yield curve, neither upsloping nor downsloping, indicates a market consensus 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 and other fixed-income investments monitor the yield curve closely because significant interest rate changes affect the cost of business financing costs and therefore the expenditure decisions of businesses across all market sectors. Collectively, those decisions are a major factor in driving the market and the economy as a whole.