What is a Yield Curve?

The yield curve is a graphical representation (line plot) of the interest rates of similar quality bonds with varying maturity dates. The most commonly reported yield curves plot the 3-month, 2-year, 5-year, 10-year, and 30-year U.S. Treasury Notes. The yield curve is compared against the interest rates paid by other debt instruments in the market. This comparison is used by economists to make economic forecasts and financial analysts to project the value of debt instruments.

How Does the Yield Curve Work?

The value of the yield curve is of future projections on interest rates. The shape of the curve takes on three main shapes: 

Normal Yield Curve 

In a normal market, the yield curve will slope upward gradually with longer-term bonds having a higher interest rate that short-term bonds. This is based on the higher level of risk associated with long-term bonds, as there is no certainty in what future bonds rates will do. Also, if you believe that future long-term rates will rise, it makes investors stick with short-term bonds (remember, if rates rise then existing bonds with lower long-term rates will be worth less). This can cause a rush to short-term securities, which lowers their yield (higher demand lowers current yield, as the issuer does not have to pay as much to attract purchasers). This makes the curve slope even steeper. 

Inverted Yield Curve 

An inverted yield curve is the exact opposite of a normal curve. Short-term yields are higher than long-term yields. This type of curve portends a future recession. When investors believe that future bond rates will continue to drop, they rush to purchase existing long-term bonds (which will be more valuable new issuances) rather than short-term bonds. The increased demand for long-term bonds raises the purchase price, but it pushes down yields further. The lack of interest in short-term bonds pushes down the price, but it raises the yield. This further inverts the yield curve. 

Flat (or Humped) Yield Curve

A flat yield curve is not really a curve. The yields on short-term and long-term bonds are very similar. This type of curve is common with economies in transition (positive to negative or vice versa). When transitioning from high to low performance, yields on long-term bonds fall and short-term bonds rise. This tends to invert the yield curve from normal to flat. When transitioning from low to high performance, there is an expectation that long-term bond yields rise and short-term rates will fall. This shifts the curve away from inverted to flatter.