What is the Normal Yield Curve?
The normal yield curve is a yield curve in which short-term debt instruments have a lower yield than long-term debt instruments of the same credit quality. This gives the yield curve an upward slope. This is the most often seen yield curve shape, and it's sometimes referred to as the "positive yield curve."
Analysts look to the slope of the yield curve for clues about how future short-term interest rates will trend. When there is an upward sloping yield curve, this typically indicates an expectation across financial markets of higher interest rates in the future; a downward sloping yield curve predicts lower rates.
Understanding Normal Yield Curve
This yield curve is considered "normal" because the market usually expects more compensation for greater risk. Longer-term bonds are exposed to more risk such as changes in interest rates and an increased exposure to potential defaults. Also, investing money for a long period of time means an investor is unable to use the money in other ways, so the investor is compensated for this through the time value of money component of the yield.
In a normal yield curve, the slope will move upward to represent the higher yields often associated with longer-term investments. These higher yields are compensating for the increased risk normally involved in long-term ventures and the lower risks associated with short-term investments. The shape of this curve is referred to as normal, over the additionally applicable term of positive, in that it represents the expected shift in yields as maturity dates extend out in time. It is most commonly associated with positive economic growth.
Key Takeaways
- The normal yield curve is a yield curve in which short-term debt instruments have a lower yield than long-term debt instruments of the same credit quality.
- An upward sloping yield curve suggests an increase in interest rates in the future.
- A downward sloping yield curve predicts a decrease in future interest rates.
Yield Curves as an Indicator
The yield curve represents the changes in interest rates associated with a particular security based on the length of time until maturity. Unlike other metrics, the yield curve is not produced by a single entity or government. Instead, it is set by measuring the feel of the market at the time, often referring to investor knowledge to help create the baseline. The direction of the yield curve is considered a solid indicator regarding the current direction of an economy and can be easily charted.
Other Yield Curves
Yield curves can also remain flat or become inverted. In the first instance, the flat curve demonstrates the returns on shorter and longer term investments are essentially the same. Often, this curve is seen as an economy approaches a recession because fearful investors will move their funds into lower risk options, driving up the price and lowering the overall yield.
Inverted yield curves present a point where short-term rates are more favorable than long-term rates. Its shape is inverted when compared to a normal yield curve, representing significant changes in market and investor behaviors. At this point, a recession is generally seen as imminent if it is not already occurring.
