Yield curve definition
/What is a Yield Curve?
A yield curve is a graphical representation of the yield on a particular type of bond, based on its maturity date. A normal yield curve shows a gradual increase in yield for bonds that mature further in the future, since it is riskier to hold the bonds for a longer period of time. An inverted yield curve presents a declining yield for bonds with longer maturities, which is typically triggered by an expectation that a recession will occur in the future. A flat yield curve is most likely during economic transition periods, when investors are uncertain about whether rates will rise or fall. Thus, it can be used to predict changes in the economy.
Economists typically review the difference between the interest rate on the 10-year Treasury note and the Fed funds rate, which is known as the interest rate spread. For example, if the federal funds rate is 1.50 percent and the 10-year Treasury note rate is yielding 3.25 percent, then the interest rate spread is 1.75 percent, or 175 basis points. This spread embodies the expectations of fixed-income traders about the economy, since their trading activity is setting the yield on the 10-year Treasury note.
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The Steep Yield Curve
When there is a steep yield curve (a large interest rate spread), this is a significant indicator of economic weakness. It typically arises when the Federal Reserve tries to counter a period of economic weakness by lowering its overnight rate, which lowers borrowing costs and therefore encourages lending, which in turn is presumably used to make purchases and fire up the economy. The problem is that the low overnight rate triggers inflationary concerns among fixed-income traders, since inflation lowers the value of principal and interest payments to be received in the future from bonds. Given this concern, the traders sell off their longer-term bond holdings, which are at most risk of a reduction in value from inflation, which lowers their prices and raises their yields. The net effect of these actions is that there is a greater interest rate spread, with a lower short-term rate and a higher yield on longer-term instruments – which represents a steeper yield curve.
The Flat Yield Curve
The reverse situation can also arise. The Fed may choose to raise interest rates in order to cool off a hot economy, since the higher rate restricts borrowing and therefore dampens purchases. This reduces the risk of long-term inflation, so fixed-income traders are more likely to buy longer-term bonds, thereby raising their prices and lowering their yields. The end result is a flatter yield curve, since the short-term interest rate is rising, while the long-rate rate is falling. When this reversal is accelerated, the yield curve can become inverted, where short-term rates are higher than long-term rates. An inverted yield curve is a reasonable predictor of a recession, since the fixed-income traders are expecting a weak economy in the future, which encourages their expectations of low interest rates over the longer-term. The inverted yield curve is not a perfect predictor of a recession, since it has predicted several recessions that did not occur.