The yield curve is an economic indicator that tracks the relationship between long- and short-term bond yields. This is the difference between short-term interest rates and long-term interest rates. In a more literal sense, yield curve refers to a line on a graph representing the relationship between the costs of borrowing money for different periods of time.
What Is the Yield Curve?
Yield curve is a term appearing frequently in financial news as a key indicator in the economy. In recent years, it’s been mentioned more often than usual because it’s displayed some unusual characteristics that may indicate troubling economic times ahead.
First, let’s define what the yield curve actually represents. The yield curve is visually displayed on a graph with the vertical (Y) axis showing interest rates at a given point in time. The horizontal (X) axis displays U.S. Treasury bonds in various maturities. These bonds come in maturities from 30 days to 30 years.
The line on that graph representing different interest rates for these bonds of varying maturities is the yield curve. Typically, the line for the yield curve has a pronounced upward slope. That is, interest rates are higher for the long-term bonds on the right side of the horizontal axis. Yield curve rates update daily on the U.S. Treasury website.
How Does the Yield Curve Work?
A number of different factors can influence the components of the yield curve. For example, short-term rates are set by the Federal Reserve as part of monetary policy to achieve goals for inflation, unemployment and economic growth. The market dictates long-term rates.
The Fed can influence short-term rates by buying and selling securities, especially Treasury bonds, to and from commercial banks. Investors influence the yield curve according to their expectations for future Fed policy. The yield curve can also illustrate the markets’ consensus opinion about future inflation rates.
The yield curve is a widely followed indicator. In a single image, it conveys information about inflation, rates, investor sentiment, government policy and the economy’s future health.
What Are the Different Types of Yield Curves?
Long-term rates are typically higher than short-term rates. This reflects the time value of money and the added uncertainty of lending for a longer period.
“Yield premium” describes the higher rates paid by long-term bonds. The yield premium also incorporates opportunity cost. Opportunity cost accounts for any potential returns that won’t be gotten by investing in other assets, such as stocks, because the money is locked up in a bond.
When the yield curve slopes steeply upward to the right, it suggests investors are convinced that future economic growth will be strong. Therefore, they want more interest for tying their money up for a longer period of time in a bond.
A flat curve appears when there isn’t much difference between short- and long-term rates. A flat curve suggests investors don’t see a lot of growth on the horizon. In that case, they are willing to lend long-term and short-term for about the same reward.
An inverted curve slopes downward to the right. It appears when short-term rates are higher than long-term rates. It signifies a prevailing market belief that the economy will weaken and the Fed will reduce short-term rates.
Inverted Yield Curve
The yield curve is one of the economic indicators people watch because it gives insight into investor forecasts about the future direction of the economy. It also hints at future interest rates.
An inverted yield curve suggests that banks will tighten lending standards, making it harder to borrow money. That can lead to an economic slowdown.
It’s not all purely theoretical. Inverted yield curves tend to predict economic slowdowns. In recent decades, when the yield curve has gone inverted, recessions have generally followed. This was true of the 2008 global financial crisis.
In 2019, for the first time in a decade, long-term rates were lower than short-term rates. As a result, the yield curve became inverted.
But many observers think the connection between an inverted yield curve and a descent into economic recession won’t hold up this time. One reason is that interest rates are lower now than in earlier instances when inverted yield curves preceded recessions. Another difference is that far more bonds are held by central banks, such as the Fed, than in previous years.
With low rates and lots of bonds in central bank vaults, the inverted yield curve may no longer indicate a coming recession. Instead, it may herald a period of slower, but positive, growth.
No matter what happens in the near future, the yield curve will continue to be a closely watched indicator. It is seen as giving clear insight into investor sentiment, monetary policy, lending practices and future economic health. Following the yield curve could help you make smart investment decisions that could greatly impact your future.
Tips for Investors
- If you’re worried about the state of the economy and your investments, consider working with a financial advisor to get an idea of where your money stands. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- With an inverted yield curve, it may be best to just be patient and keep your money invested where it is. It could be tempting to pull your money out from a long-term investment to move it to a short-term investment with a higher interest rate, but that could backfire if and when the yield curve returns to its normal state in the future. Before doing anything, consult your financial advisor.
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