In business and finance, people talk a lot about "the yield curve." They usuallymean the curve that appears when you plot the yield (rate of return) of Treasury bonds as afunction of their time to maturity. While that may sound like insider jargon for financeprofessionals, the shape of that curve is widely referenced in mass media because it hasbecome one of the most closely watched recession predictors in the world.
What Is the Yield Curve?
A yield curve is the collection of all the different yields on bonds being sold by an issuer(or sometimes a whole category of issuers) and their associated times to maturity (the finalrepayment date). The "curve" is the shape that those data points make whengraphed, or the shape of the line that connects the dots, so to speak.
Consider a company or government issuing bonds (an investment that pays investors back withinterest). For reasons explained below, bonds that pay back their investors sooner usuallyoffer lower rates of return (yields) than bonds that pay off later — assuming allother factors are equal. So, for example, a bond that pays back its investment in a yearmight have a yield of 2%, while one that takes 10 years to repay investors might pay 4%.
The most closely watched yield curve is the one that plots the yields of bonds, akafixed-income securities, issued by the U.S. Treasury (or "Treasuries" for short).And when people talk about the yield curve, without any other context, they mean the yieldcurve of those Treasuries (at least in the United States).
Key Takeaways
- "The yield curve" usually refers to the set of yields on Treasury bonds on anygiven day, plotted as a function of how long the bonds take to "mature" (payback investors).
- The shape of the yield curve is influenced by expected future changes in interest rates,which means it reflects investors' expectations about future economic conditions.
- Both theory and history tell us that an inverted yield curve can be an advance warningthat a recession is coming — but it provides little information on how soon or howsevere that recession may be.
The Yield Curve Explained
Truly understanding why the yield curve is so important to economic analyses requiresdetailed knowledge of the principles and mechanisms by which bond markets operate.Professional investors may wish to skip this section.
Let's start with a basic question: What's a yield? To investors, "yield"means a specific interest rate: the promised rate of return on a bond, which is a type offixed-income security. The security is called "fixed income" because its repaymentdates and payoff amounts are set in advance. Bonds "mature," meaning, they end.There's a date on which an investor gets his or her final (often largest) payment, andthe bond ceases to exist — it is no more. The yield is the annual rate of return thatthe bond pays on a buyer's initial investment. A bond that costs $1,000 today and pays$1,080 when it matures next year has a yield of 8%, while an otherwise identical bond thatpays $1,050 has a yield of 5%. Some bonds mature in one year (or even less), while others goout to 30 years. A 30-year bond with a 5% yield may cost $1,000, then pay $50 a year, everyyear, until the final year, when the investor gets the initial investment back with thefinal interest payment (a $1,050 final payment).
Bond yields are established by a market mechanism in which investors buy bonds from theoriginal issuers and then buy and sell those bonds among themselves. The same way the stockmarket sets prices for shares of stock, markets also set prices (and, therefore, yields) ofbonds. If a $1,000 bond matures next year and pays $1,080, selling it at $1,000 is sellingat a yield of 8%. Selling that bond for $990 would imply a higher yield (it's a higherrate of return when $990 grows into $1,080 than when $1,000 grows into $1,080). A sellingprice of $1,010 would imply a lower yield than 8%. As this example shows, yields and pricesmove in opposite directions. If an investor — or government or business — isselling or issuing a bond (issuing means selling a bond you create instead of one you boughtfrom someone else), that seller wants a lower yield because it means a higher price.Investors who are buying bonds, on the other hand, want a higher yield (i.e., a lowerprice).
How Yield Curves Work (Or, Short-Term Rates Impact Long-Term Rates)
The last bit of market mechanism necessary to understand the yield curve is how short-termyields influence long-term yields. Consider bonds with one- and two-year maturities thatboth pay 5%. If rates never changed, and you wanted to make a two-year investment, itwouldn't matter whether you bought the two-year bond today or a one-year bond today andanother one-year bond a year from now when the first bond pays out. You'd wind up withthe same amount of money in two years either way, all else being equal.
Why Yield Curves Are Important
But what if you were convinced that interest rates were going to increase a year from now?Suddenly, the one-year bond looks more attractive because you could reinvest your moneyafter year one at a higher rate and end up with more money in two years' time than youwould if you bought the two-year bond. Yields on the two-year bond must rise to makeinvestors willing to buy it. Conversely, if you were convinced that in a year's timeone-year bonds would pay less than 5%, you'd prefer the two-year bond because it locksin a higher rate. This is how short-term interest rates impact long-term interest rates: Theexpected changes in short-term rates impact what kind of long-term rates investors arewilling, eager or hesitant to accept.
Constructing a Yield Curve
Now let's define the yield curve. It's a graph where the x-axis is time to maturityof bonds and the y-axis is the yield of those bonds. Each bond from 30 years down to oneyear or less has a point on the graph that represents its maturity and yield, and the yieldcurve is the line drawn through the points to connect the dots. It's a curve of yields,as a function of the bonds' time to maturity.
You can draw lots of yield curves for different types of bonds, from AAA-rated municipalbonds to corporate "junk bonds." But when people talk about "the yieldcurve," they mean the one for U.S. government debt — bonds issued by the U.S.Treasury. These bonds are common, well-understood and frequently traded (meaning,they're highly liquid and there's good, current data about yields). They'realso seen as being among the safest investments in the world. Here's the yield curvefor U.S. Treasuries on May 5, 2022:
Clarifying vocabulary. Listen closely, and you'll hear investors talkabout Treasury "bills" (or T-bills) and Treasury "notes" (T-notes), aswell as Treasury bonds. In the world of Treasury securities, "bonds" usuallyrefers to long-term bonds (those with 20- and 30-year maturities), while "notes"is shorthand for "medium-term bonds" (maturing in two to 10 years) and"bills" refers to the shortest-term securities (less than two years). Sincethey're all technically bonds, to reduce possible confusion I refer to them all asbonds in this article.
What Influences the Yield Curve?
The influences that shape the yield curve come from the market conditions that determineTreasury bond yields and from one very important interest rate: the federal funds rate. Thefed funds rate is set by policymakers at the U.S. Federal Reserve and has a powerfulinfluence on how the market prices bonds. Let's explore each of these influences.
How Market Mechanisms Influence the Yield Curve
Yields, even on new bonds that come directly from the issuer, are mostly determined by marketconditions. New bonds are usually auctioned off, in which case the market directly sets theprice, although sometimes they are sold to an investment bank or consortium of banks, whichnegotiates a price with the issuer. Either way, once bonds are issued to their firstinvestors, they can be traded in the secondary market at different prices and yields —whatever the market will bear. Markets set bond yields via price negotiation between buyerand seller, the same way the stock market sets share prices. If the market price for a bondpaying $1,020 next year is $1,000, the market yield for that bond is 2% (and if the price isbelow $1,000, the yield will be higher, while a higher price would result in a lower yield).
So how do investors decide on good bond prices? The first thing investors care about is risk,or how safe their dollars are. Riskier investments need to pay higher yields (i.e., bepriced lower) to attract investors because of the higher chance that the investment willnever get fully repaid. This is one reason that the slope of most yield curves has someupward pressure: Longer waits carry higher risk that something could happen to disrupt thesafety of the investment before it's paid back, so longer-term bonds need to pay higheryields, all else being equal.
But when it comes to default risk, Treasury bonds are seen as being as close to risk-free asan investor can get. Therefore, changes in the Treasury yield curve are almost entirely dueto changes in market conditions, as opposed to changes in the creditworthiness of the bondissuer. That's a big reason why the Treasury yield curve is so closely watched as abellwether for market conditions.
Another thing investors care about is liquidity, or how easy it is to get their money out ofthe investment if they need it. This is another reason why yield curve slopes have upwardpressure: If you have to sell a bond before its maturity, the longer you hold it the betterthe chances that market conditions will have changed and the price may have dropped. Justbecause you can hold a bond to maturity and get all your money back doesn't guaranteeyou'll be able to recoup your entire initial investment at any point between purchaseand maturity. So, investors tend to want a little more yield as compensation for liquidityrisk. But again, with Treasuries, investors generally need not worry about actually findinga buyer for their bonds should they need to sell (even though Treasury bonds of differentmaturities do have different liquidities, so there is a very small risk that an investor mayhave to accept a lower price if selling a lot of a less-frequently traded maturity).
How the Fed Funds Rate Influences the Yield Curve
The federal funds rate is a special interest rate controlled by the Federal Reserve'sFederal Open Market Committee (FOMC). This is a very short-term rate, the overnight rate atwhich financial institutions lend to one another. But in a world where Treasury bonds fromfour weeks to 30 years are set by market forces, how much impact can a single,policy-managed, one-day rate really have?
A lot, as it turns out. Remember that long-term rates are influenced by short-term rates. Ina previous example, the one-year rate (and expected future changes in it) influenced whatkinds of rates investors were willing to accept on two-year bonds. The same logic applies tothe overnight rate as well. Just as, next year, a two-year bond becomes a one-year bond, aone-year bond becomes an overnight loan in 364 days. So, if shorter-term rates are expectedto be high and stay high, longer-term rates will be high as well. If shorter-term rates areexpected to fall and stay low, longer-term rates will fall. And there are no shortershort-term rates than the fed funds rate, which makes the power to set that rate a verypowerful policy lever, indeed.
So, why might the Fed use that lever to raise or lower rates? To maintain the economy in astate of steady expansion, which, more specifically, means managing its dual mandate: tosupport both high levels of employment and a stable currency value (i.e., keeping inflationlow). Raising rates is a common way to fight inflation. Higher interest rates mean thatborrowing is more expensive, which means that money isn't as "cheap" as itwas before. It can be a way to tap the brakes on the speed at which money flows through theeconomy or, said another way, make borrowed dollars slightly harder to come by, which meansthey're scarce, which has an anti-inflationary effect. Think of simplesupply-and-demand principles: When things are scarce, they're worth more. Loweringinterest rates is a way to stimulate the economy by making investments cheaper, be they innew business ventures or in personal assets typically bought with financing help (such ashomes and vehicles). This is why the fed funds rate moves around; it changes in response toeconomic conditions.
Expectations about the future of the economy, then, inform expectations about what the Fedwill do with interest rates, which, in turn, influence what kind of yields investors arewilling to accept on bonds. Said another way, on any given day, the yield curve representsmarket expectations regarding economic developments and policy responses to thosedevelopments. Which brings us to…
Why Are Different Shapes of Yield Curves Important?
If you're a bond trader or investment banker, yield curves are going to be important toyou every day. If you're a business school professor or economics blogger, you'llencounter them slightly less often, but still fairly frequently. For business leaders andmanagers, the yield curve is probably newsworthy only when its shape becomes unusual,because that typically means the market is expecting changing — and uncertain —economic times ahead.
Normal curve:
When the yield curve is normal (slightly upward sloping, steeper on the left with theshorter-term bonds), that's a sign that economic conditions are expected to remainstable, or status quo, for the time being.
Steep curve:
When the yield curve gets unusually steep and upward sloping, that's a sign that themarket expects interest rates to rise, with high probability and/or by large amounts. Thisoften happens when inflationary pressures are significant and persistent enough to warrant astrong policy response, and traders think the Fed will raise rates to combat that inflation.
Flat curve:
When the yield curve gets flat, that could be a sign that rates are expected to drop andthere's uncertainty ahead — in other words, some expectations of the future areoffsetting the normal upward pressures on the curve's slope.
Inverted curve:
The shape that's most closely monitored and is consistently the most newsworthy,however, is an inverted yield curve. It's newsworthy because inverted yield curves tendto precede economicrecessions. An inverted yield curve is one that slopes downward, despite all theupward pressure to rise. It means investors are willing to pay more (accept lower yields)for longer-term bonds than for shorter-term bonds. Why would they do that? In most cases,it's because they expect that when they get paid back from the shorter-term bonds,interest rates will be a lot lower. So, they will wish they had locked in a higher rate fora longer time, even if that long-term rate was lower than the then-current short-term rate.Different experts measure inversion differently, but most metrics involve looking at thepoint where a particular shorter-term rate (the three-month and two-year rates are verypopular) is higher than a chosen longer-term rate (usually the 10-year rate).
Humped curve:
If a yield curve shows a hump, that means market investors expect medium-term rates to behigher than short-term rates and long-term rates. One of several possible interpretations isthat humped yield curves are inverted yield curves where the inversion starts later,suggesting that a recession is predicted but not until after rates rise. Humped curves arerare — but the Treasuries yield curve was, in fact, humped in April 2022, as discussednext.
Using Yield Curves to Forecast Recessions
Inverted yield curves reflect strong expectations of future rate-cutting. Why might the Fedcut interest rates in the future, and why might bond investors believe it will do sodramatically enough to cause an inverted yield curve? Interest rate reductions are aneffective form of economic stimulus, and a common response to a recession. And that, in anutshell, is why an inverted yield curve is seen as a harbinger of tough economic timesahead.
However, yield curve inversions aren't always easy to determine. Sometimes the curveisn't entirely downward sloping, but does have a hump. For example, on April 1, 2022,the yield curve shown below sloped upward through the three-year rate (2.61%) beforedeclining through the 10-year rate (2.39%). If you were measuring inversion by comparing the10-year rate to the three-month rate (0.53%), you'd say it's not even close tobecoming inverted; comparing the 2.39% of the 10-year to the two-year at 2.44% would lead toa “slight inversion, but fairly flat” conclusion. But from the 2.61% peak atthree years,the curve shows a steady, almost linear decline to the 10-year rate. When dealing with lesssimple shapes, it pays to look at the whole picture and not just track a single metricmarking the difference between two numbers, as news organizations frequently do for the sakeof simplification.
The shape of the April 1, 2022 yield curve tends to reflect expectations that interest rateswill rise and then fall. Many economists expect that shape anticipates the need to fight inflation, followed by a need to fight arecession.
Recessions don't always come immediately after a yield curve inverts. Sometimes a yieldcurve will invert, normalize and invert again before that happens. Sometimes it's along time between an inversion and the next recession. The yield curve also can't tellyou how bad a recession will be. But despite these shortcomings, among all the recessionindicators economists have identified, an inverted yield curve is one of the mostconsistently reliable.
What Do Yield Curves Tell Businesses?
Knowing that an economic downturn is on the horizon is powerful for businesses, which canthen take appropriate action to make their operation as recession-proofas possible. And the yield curve is among the best recession indicators we have.
Yield curves and business cycles.
Because the shape of the yield curve is at least partially based on expectations of futurerates, and because future fed funds rate changes are often policy responses to economicconditions, many analysts and forecasters use the yield curve to infer market expectationsfor economic cycles. But while the yield curve is a good predictor of bad times ahead,it's less effective at predicting good times. An inverted yield curve is a particularlygood predictor of recessions because the upward pressure on the slope means that the shapeis biased toward a positive slope — more simply, the yield curve is biased againstsignaling a recession. So, when a recession signal is observed, it usually represents afairly strong market prediction. Using an upward sloping yield curve to forecast a positiveturn in business cycles, however, is riskier, since that's the natural shape absent anystrong predictions.
How Do Yield Curves Impact Businesses?
Beyond recession forecasting, yield curves can have another value for business managers. Forcompanies looking to access capital markets from which to borrow money, finding a yieldcurve of comparable bonds (e.g., similarly creditworthy corporate bonds instead ofTreasuries) usually provides an excellent way to estimate borrowing costs. Smaller companiesmay be able to note unusual shapes to guide borrowing decisions as well.
For example, a very steep curve may mean borrowing costs are expected to rise markedly, soborrowing earlier could save money, compared to waiting until the last minute. A humped orbumpy yield curve could mean it's a good time to shop around and ask your lenders aboutdifferent lengths of loans, to see where rates might be most favorable.
Conclusion
The Treasury yield curve is closely watched because it can tell business leaders a lot aboutmarket expectations for the economy. While at first blush it may seem like reading tealeaves or Tarot cards, translating the shape of a curve into economic forecasts has realeconomic theory behind it. Even more important than theory, an inverted Treasury yield curvehas, in practice, repeatedly demonstrated its value as a useful recession indicator.
#1 Cloud
Planning Software
Free ProductTour
Yield Curve FAQs
What does the yield curve tell you?
A yield curve tells you the yields of a set of fixed-income securities (bonds) as a functionof their time to maturity. When people talk about the yield curve, they usually mean bondsissues by the U.S. Treasury. Certain shapes of the yield curve can tell you about expectedfuture changes in interest rates, and an inverted yield curve (one that slopes downward) isa commonly watched indicator that may foretell a coming recession.
Why does the yield curve matter?
The yield curve is important because of its usefulness in forecasting economic conditions. Aninverted yield curve has a good track record for predicting recessions.
What does a normal yield curve look like?
A “normal” yield curve is typically upward sloping, steeper on the left andflatter on theright, similar to a square root or log function. Normal yield curves slope upward becauseinvestors typically (though not always) demand higher yields for longer-term investments;they generally require accepting more risk and less liquidity than shorter-term investments.
