What Is a Yield Curve?
A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity.
There are three main shapes of yield curve shapes: normal (upward sloping curve), inverted (downward sloping curve), and flat.
- Yield curves plot interest rates of bonds of equal credit and different maturities.
- The three key types of yield curves include normal, inverted, and flat. Upward sloping (also known as normal yield curves) is where longer-term bonds have higher yields than short-term ones.
- While normal curves point to economic expansion, downward sloping (inverted) curves point to economic recession.
- Yield curve rates are published on the Treasury’s website each trading day.
How a Yield Curve Works
A yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates, and it is used to predict changes in economic output and growth. The most frequently reported yield curve compares the three-month, two-year, five-year, 10-year, and 30-year U.S. Treasury debt. Yield curve rates are usually available at the Treasury's interest rate websites by 6:00 p.m. ET each trading day.
A normal yield curve is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time. An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields, which can be a sign of an upcoming recession. In a flat or humped yield curve, the shorter- and longer-term yields are very close to each other, which is also a predictor of an economic transition.
Types of Yield Curves
Normal Yield Curve
A normal or up-sloped yield curve indicates yields on longer-term bonds may continue to rise, responding to periods of economic expansion. A normal yield curve thus starts with low yields for shorter-maturity bonds and then increases for bonds with longer maturity, sloping upwards. This is the most common type of yield curve as 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.
A normal yield curve implies stable economic conditions and should prevail throughout a normal economic cycle. A steep yield curve implies strong economic growth in the future—conditions that are often accompanied by higher inflation, which can result in higher interest rates.
Inverted Yield Curve
An inverted yield curve instead slopes downward and means that short-term interest rates exceed long-term rates. Such a yield curve corresponds to periods of economic recession, where investors expect yields on longer-maturity bonds to become even lower in the future. Moreover, in an economic downturn, investors seeking safe investments tend to purchase these longer-dated bonds over short-dated bonds, bidding up the price of longer bonds driving down their yield.
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.
Flat Yield Curve
A flat yield curve is defined by 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.
What Is a U.S. Treasury Yield Curve?
The U.S. Treasury yield curve refers to a line chart that depicts the yields of short-term Treasury bills compared to the yields of long-term Treasury notes and bonds. The chart shows the relationship between the interest rates and the maturities of U.S. Treasury fixed-income securities. The Treasury yield curve (also referred to as the term structure of interest rates) shows yields at fixed maturities, such as one, two, three, and six months and one, two, three, five, seven, 10, 20, and 30 years. Because Treasury bills and bonds are resold daily on the secondary market, yields on the notes, bills, and bonds fluctuate.
What Is Yield Curve Risk?
Yield curve risk refers to the risk investors of fixed-income instruments (such as bonds) experience from an adverse shift in interest rates. Yield curve risk stems from the fact that bond prices and interest rates have an inverse relationship to one another. For example, the price of bonds will decrease when market interest rates increase. Conversely, when interest rates (or yields) decrease, bond prices increase.
How Can Investors Use the Yield Curve?
Investors can use the yield curve to make predictions on where the economy might be headed and use this information to make their investment decisions. If the bond yield curve indicates an economic slowdown might be on the horizon, investors might move their money into defensive assets that traditionally do well during recessionary times, such as consumer staples. If the yield curve becomes steep, this might be a sign of future inflation. In this scenario, investors might avoid long-term bonds with a yield that will erode against increased prices.