Definition
Also known as the “term structure of interest rates,” the yield curve is a line that plots the yields of similar-quality bonds against their maturities within the shortest and longest range. A comparison of the three-month, two-year, five-year, 10-year and 30-year U.S. Treasury debt is the most frequently reported yield curve. Other debts in the market including mortgage rates or bank lending rates use this yield curve as a benchmark. The Treasury’s interest rate websites provide yield curve rates by 6:00 PM ET each trading day. Yield curves are also calculated and published by The Wall Street Journal, the Federal Reserve, and a variety of other financial institutions.
How does the yield curve works?
Future interest rate changes and economic activity can be determined by the shape of the yield curve. The three main types of yield curve shapes are normal, inverted, and flat (or humped). Longer maturity bonds that have a higher yield compared with shorter-term bonds as a result of the risks related with time is shown in a normal yield curve. Short-term yields on the other hand, that are higher than the longer-term yields which may mean a recession is about to happen is demonstrated in an inverted yield curve. In a flat or humped yield curve, predicts an economic transition as it shows that the shorter and longer-term yields are very close to each other. Generally, yield curves that show positive indications mean investors require a higher rate of return for taking the additional risk they have to deal with for lending money for a longer period of time.
Normal Yield Curve
A curve that indicates yields on longer-term bonds that may continue to arise is a normal or up-sloped yield curve. It means its responding to periods of economic expansion. Investors would temporarily place their funds in shorter-term securities if longer-maturity bond yields are expected to become even higher in the future. It gives the chance to purchase longer-term bonds later for higher yields. The risk involved in a rising interest rate environment suggest it's not advisable to have investments tied up in long-term bonds when their value has yet to decrease due to the higher yields over time. Their yields are pushed even lower because of the increasing temporary demand for shorter-term securities which then leads to a steeper up-sloped normal yield curve.
Inverted Yield Curve
A curve that demonstrates yields on longer-term bonds that may continue to fall is an inverted or down-sloped yield. It corresponds to periods of economic recession. Many investors would resort to purchasing longer-maturity bonds to lock in yields before they decline even more when longer-maturity bonds yields are expected to go down in the future. Prices are higher but yields are low on longer-maturity bonds and prices decline but higher yields on shorter-term securities when there is an increasing onset of demand for longer-maturity bonds and the lack of demand shorter-term securities. It further leads to an inverting down-sloped yield curve.
Flat Yield Curve
Base on the changing economic conditions, a flat yield curve occurs from the normal or inverted yield curve. When the economy starts to change from expansion to slower development and even recession, it leads to the fall of yields on longer-maturity bonds and rise of yields on shorter-term securities. The normal yield curve is then inverted into a flat yield curve. When the economy changes from recession to recovery and possible expansion, yields on longer-maturity bonds are set to go higher and yields on shorter-maturity securities are sure to decline. It leads to the tilting of an inverted yield curve toward a flat yield curve.
Investors find yield curves a very helpful graph and source of a great deal of information since it generally indicates future interest rates. They are an indicator of an economy’s expansion or contraction as discussed in the breakdown above. The yield curve and the changes that occur plays an important role in the decision-making of every investor. A Duke University professor named Campbell Harvey in the 1990s found out that inverted yield curves have preceded the last five United States recessions. The concepts being brought upon yield curves becomes a motivator to the analysts and investors in studying them carefully to get a more accurate result.
