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Yield curve definition
The yield curve is a line graph showing interest rates of Treasurys or other bonds with different maturity dates. The slope of the yield curve is used as a reliable indicator of future interest rate changes and the general health of the economy.
There are a few types of yield curves, but the most important are normal, flat and inverted.
Understanding the yield curve
There are a few components when it comes to understanding what the yield curve is and what it represents. The U.S. government borrows money from investors in the form of Treasurys. Some Treasurys are short-term, meaning the government promises to pay them back relatively soon, and others are long-term. Those long-term loans tend to pay a higher interest rate (or yield) than short-term loans. For instance, a 30-year Treasury would have a higher interest rate than a six-month Treasury.
When the economy is healthy, Treasury yields aren’t all that attractive compared with the stock market or other kinds of investments since they typically have lower returns.
» Learn more about stocks vs. bonds
But when there are fears that the economy isn’t going to perform well, some investors tend to flock to Treasurys since the government is a safe bet for paying money back. But if the demand for government Treasurys goes up, such as when people are nervous about the economy and want to invest in something safe, the government can offer lower interest rates.
This is where the yield curve comes in: During healthy markets, the chart will curve up and to the right, meaning that the shorter-term Treasurys have lower interest rates and the longer-term ones will have higher interest rates. When investors think the economy will continue expanding, they demand a higher return for locking up money in a longer-term investment.
But when investors are worried about the future of the market, and the demand for Treasurys increases, the rates for long-term Treasurys can fall below that of the short-term Treasurys (for example, if a two-year Treasury is paying 2% and a 10-year Treasury is paying 1.5%). That means people want to get their money into a longer-term investment where it can withstand upheaval, so it takes higher returns to attract them to shorter-term bonds. When that happens, the curve on the graph turns upside down, creating an inverted yield curve.
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Yield curve types
There are four types of yield curves. Here is a brief rundown of each.
1. Normal yield curve. A normal yield curve slopes up from left to right, and indicates that investors expect the economy to grow at a regular pace. This is when short-term Treasurys will have lower interest rates than long-term Treasurys.
2. Flat or humped yield curve. This is when short-term rates rise and are closer to long-term rates. The chart will look like a road with a speed bump in it: Flat on either side with a hump in the middle. Flat or humped yield curves may be a step toward an inverted yield curve.
3. Inverted yield curve. Inverted yield curves occur when long-term Treasury interest rates fall below those of short-term Treasury interest rates. This is a strong economic indicator that an economic slowdown or recession is on the horizon.
4. Steep yield curve. A steep yield curve is basically the opposite of an inverted yield curve: It occurs when 30-year Treasurys have interest rates that are more than 2.3 percentage points higher than a three-month Treasury. Steep yield curves often indicate a period of economic growth.
Yield curve as an economic indicator
The reason the yield curve is so revered as an economic indicator is because it’s not often wrong. When the yield curve is inverted, it’s often a sign that a recession is in the near future. The yield curve has accurately predicted the last six recessions. And while there is no way the yield curve could have foreseen the COVID pandemic, it did invert in August 2019. No one knows exactly how long after the yield curve inverts that a recession will occur (or even if there will be one at all).
And even though the yield curve is an economic indicator with a reliable track record, it’s a good rule to never try to predict the market.
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