When markets feel uncertain, many investors look for signals about what might come next. One helpful tool is the yield curve, which offers insight into where the economy could be headed.
The yield curve is a graph that shows the relationship between interest rates and the time it takes for fixed-income securities, like bonds or Treasury notes, to mature. If you’re an economist, policymaker, or investor, you probably tend to closely watch the yield curve, which the U.S. Department of the Treasury updates daily.
The curve’s shape—steep, flat, or inverted—might signal economic growth, slowing momentum, or even a possible recession. Understanding how to read the yield curve can give you valuable context for today’s interest rate environment and what may lie ahead.
Yield Curve Meaning and Definition in Finance
What is the definition of the yield curve exactly? It’s a tool for tracking how interest rates change over time. It shows how interest rates vary across bonds of the same credit quality—usually U.S. Treasury securities—but with different maturity rates.
Because Treasury bonds are widely seen as safe investments, their yield curve is often used as a benchmark for the broader bond market. You may also hear the yield curve referred to as the “term structure of interest rates”—a more technical phrase that means the same thing.
How Does the Yield Curve Work?
The yield curve shows interest rates (or yields) on the vertical axis and time to maturity on the horizontal axis. It maps out how much return investors expect for lending money to the government over different time periods.
The typical yield curve charts U.S. Treasury bonds with maturities of three months, two years, five years, 10 years, and 30 years.1 The shape of the yield curve reflects how investors feel about the economy—whether they’re optimistic, cautious, or expecting a slowdown.
Why Is the Yield Curve Important for Investors?
If you’re an investor, here are three big ways the yield curve can be important:
- It can provide insight into economic expectations, such as growth, inflation, and recession.
- It can act as a benchmark. Treasury yields influence corporate, mortgage, and municipal rates.
- It can affect portfolio allocation, helping investors balance risk between stocks and bonds.
What Are the Different Types of Yield Curves?
The shape of the yield curve depends primarily on maturity risk premium and term premium:
- Maturity Risk Premium: Investors expect extra returns for the added risk of holding bonds for a longer period of time. These added returns are called maturity risk premiums.2
- Term Premium: The expectation about future economic growth, inflation, and monetary policy is called term premium.3
Demand for money is higher when the economy is growing because greater spending activity demands higher funds to finance projects. Higher demand, in turn, drives up interest rates. Strong economic growth usually leads to higher inflation.
In periods of economic expansion, investors expect the bond yields with longer maturity to be higher than shorter-term bonds because they expect higher future interest rates as well as inflation. This difference between short-term and long-term rates is known as the “spread.” Higher spread gives an upward sloping yield curve.
Normal Yield Curve
This is the typical yield curve shape: upward sloping. It means longer-term bonds pay more interest than short-term ones, which suggests the economy is growing normally. It slopes upward, and that slope can be mild or steep.
Inverted Yield Curve
An inverted yield curve happens when short-term interest rates are higher than long-term rates. This may seem like a paradox at first glance. Why would investors settle for lower yields holding longer maturity compared to shorter-term? Because they expect future rates to drop even further, since they have little confidence in the economy’s growth.
A negative term spread (typically, the difference between 10-year and two-year yields) predicts weaker economic growth in the future with a high probability of recession. Economic research shows that the yield curve inverted before every recession from January 1955 to February 2018.4
Although people consider yield curve inversion a harbinger of recession, the inversion alone doesn’t necessarily signal that a recession is coming. But the longer the yield curve remains inverted, the more accurately it may generally predict a recession, especially in the United States, when rising effective federal fund rates (FFR) accompany it.
Flat Yield Curve
A flat yield curve indicates that little if any difference exists between short-term and long-term rates for bonds and notes of similar quality. Flat curves often indicate the economy is slowing down and that investors are uncertain about its future, including aggregate demands, inflation, and the future value of stocks and bonds.
Yield Curve and Interest Rates: What’s the Connection?
Federal Reserve interest rate decisions can heavily influence the short end of the curve. Market forces—such as inflation expectations, global demand for U.S. bonds, and the economic outlook—can drive the long end.
What Does the Yield Curve Signal About the Economy?
Although the shape of the yield curve shows expectations of interest rates and economic activity, it’s important to distinguish the drivers of the short end and long end of the curve.
Short-term interest rates are a function of the Federal Reserve’s Federal Open Market Committee’s (FOMC) monetary policy actions with its target federal funds rate. The Fed FOMC attempts to “ease” by lowering the target rate and attempts to “tighten” by increasing the target rate. On the other hand, the changes in higher yields on longer-term maturity can indicate future economic growth and inflation.
Investors often look to the yield curve as a signal of where the economy could be headed. But it’s important to remember that while it can be a helpful indicator, it doesn’t tell the whole story on its own.
Understanding the Yield Curve in Your Investment Strategy
Wondering how to use the yield curve to help map your investment strategy? The yield curve is just one resource—or financial data point—among many you can use in your decision-making process. Your financial advisor can help guide you with all the information at his or her disposal.
Want help integrating yield curve analysis into your portfolio strategy? Find an advisor tailored to your investment goals.
FAQs
What does an inverted yield curve mean?
It means short-term interest rates are higher than long-term rates, which can be a warning sign of a possible recession.
How often does the yield curve change?
It changes every day as bond prices and interest rates move.
Who controls the yield curve?
The Fed controls short-term rates, but the long-term side depends on investors and the market.
Can the yield curve predict recessions?
Yes. An inverted yield curve preceded almost every U.S. recession in the past 50 years.
1 Nasdaq, “How to Calculate Maturity Risk Premiums,” March 4, 2016, https://www.nasdaq.com/articles/how-calculate-maturity-risk-premiums-2016-03-04.
2 Federal Reserve Bank of San Francisco, “What is the Term Premium?” Economic Letter, July 16, 2007, https://www.frbsf.org/research-and-insights/publications/economic-letter/2007/07/term-premium/#subhead1.
3 U.S. Department of the Treasury. Treasury Yield Curve Methodology. https://home.treasury.gov/policy-issues/financing-the-government/interest-rate-statistics/treasury-yield-curve-methodology.
4 Federal Reserve Bank of San Francisco, “Economic Forecasts with the Yield Curve,” Economic Letter, March 5, 2018, https://www.frbsf.org/research-and-insights/publications/economic-letter/2018/03/economic-forecasts-with-yield-curve/
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