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.

  1. What is the difference between term structure and a yield curve?

    Understand the difference between the term structure of interest rates and a yield curve, if any. Learn what the yield curve ... Read Answer >>
  2. Which economic factors impact Treasury yields?

    Learn about the economic factors that impact Treasury yields. These yields are the benchmark yield for debt notes around ... 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

    Understanding The Treasury Yield Curve Rates

    Treasury yield curves are a leading indicator for the future state of the economy and interest rates.
  3. Investing

    Understanding Treasury Yield And Interest Rates

    By understanding the factors that influence treasury yield and interest rates, you can learn to anticipate their movement and profit from it.
  4. Insights

    Four Scenarios: Fed Policy, the Yield Curve and Recessions

    If you were to compile a list of the most effective recession predictors, the term spread, or difference between short and long-term interest rates, would likely be at the top of that list.
  5. Investing

    How Bond Market Pricing Works

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

    How Rising Interest Rates and Inflation Affect Bonds

    Understand bonds better with these four basic factors.
  7. Insights

    Some Like it Hot (The Economy, That is)

    We look at past market reactions as the Federal Reserve contemplates higher interest rates, and what the yield curve may be saying about stocks.
  8. Investing

    Get Ready For The Coming Bear Market and Recession

    A bullish strategist now says that stocks are in the "9th inning"
  9. Investing

    3 Risks U.S. Bonds Face in 2016

    Learn about the major risks for the bond market in 2016; interest rate increases, high-yield bond volatility and a flatter yield curve may be issues.
  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. Yield Curve Risk

    The yield curve risk is the risk of experiencing an adverse shift ...
  4. On-The-Run Treasury Yield Curve

    The on-the-run Treasury yield curve is derived from on-the-run ...
  5. Growth Curve

    A growth curve is a graphical representation of how a particular ...
  6. Negative Butterfly

    A negative butterfly is a non-parallel yield curve shift in which ...
Trading Center