Yield Curve

What Is a Yield Curve?

A yield curve is a graph that shows the relationship between interest rates (or yields) of bonds that have the same credit quality but different lengths of time until they mature. It helps investors and economists understand how interest rates might change over time, and it can provide clues about the future state of the economy.

Types of Yield Curves

1. Normal Yield Curve: This upward-sloping curve shows that bonds with longer maturity dates have higher yields than those with shorter maturities. It usually indicates that investors expect the economy to grow and inflation to rise, so they demand more return for taking on the risk of long-term investments.

2. Inverted Yield Curve: The downward-sloping curve happens when short-term interest rates are higher than long-term rates. It's often seen as a warning sign of an economic recession because it suggests that investors expect slower growth and lower inflation ahead.

3. Flat Yield Curve: This curve shows almost the same yield across bonds of different maturities. It suggests uncertainty about the future of the economy, where there are mixed signals about growth or inflation.

Importance of the Yield Curve

Economic Indicator: It gives us clues about what investors expect for the economy. A steep curve usually signals confidence in future growth, while an inverted curve can signal a potential recession.

Investment Decisions: Investors use the yield curve to decide which bonds to buy. Example, if the curve is normal, they may prefer long-term bonds. But if it’s inverted, they might look for short-term bonds or safer investments.

Risk Assessment: The shape of the yield curve helps investors understand potential risks. If the curve changes shape, it can signal changes in interest rates, which affect bond prices and returns.