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Yield Curve

The yield curve is a line that plots the relationship between yields and maturities of fixed income securities.

What Is a Yield Curve?

The term "yield curve" refers to the graphical representation of the relationship between yields and maturities in fixed income markets.

The yield curve is a graphic depiction of the rates of return that investors can expect from various maturities of fixed-income securities, such as bonds and treasury bills. The shape of the curve is determined by the level of interest rates that prevail in the economy. Lower interest rates are associated with increasing levels of longer-term debt instruments. Higher interest rates are associated with decreasing levels of longer-term debt instruments.

It is a significant financial instrument used by investors to predict the economy’s direction. It compares the interest rates of short, medium, and long-term government bonds.

The yield curve represents the relationship between bond yields, expressed as an interest rate per year, and the maturity dates. 

Normal Yield Curve vs Inverted Yield Curve

A normal yield curve is upward sloping, meaning that longer-term maturities have higher interest rates than shorter-term ones. This phenomenon is known as "normal" because it usually represents an economic environment in which people are willing to invest for the long term at greater risk in exchange for higher returns. 

When the curve is inverted, or when short-term interest rates are higher than long-term ones, it indicates a negative economic outlook. An inverted yield curve can precede a recession.

Because of its close association with potential economic changes, the yield curve has important implications for investors and other market participants. For example, if the yield curve flattens out or becomes more horizontal, it indicates that investors are comfortable holding less risky assets for longer periods. This could signal a weaker economy as consumers begin to spend less and save more ahead of anticipated economic uncertainty.

The yield curve is used to gauge whether an economic activity is likely to accelerate or decelerate in the near future. Economists view an upward sloping yield curve as a sign that growth is likely to pick up while a downward sloping curve is taken as a sign that growth is expected to slow.

When the yield curve changes shape, it can signal that specific segments of the economy are about to outperform or underperform their peers. For example, if short-term interest rates rise relative to longer-term rates, it could be a sign that inflationary pressures are building and that a higher rate of inflation might not be far off. If long-term rates rise relative to short-term rates, it could be a sign that growth expectations are rising faster than inflationary expectations and that higher short-term interest rates might be on the horizon.

How to Measure Yield Curves

The spread between the rates of ten-year treasuries and two-year treasuries is one of the most often used techniques of determining whether the yield curve is flattened. This spread is charted by the Federal Reserve, and it is one of their most widely downloaded data series. It is updated on most business days.

One of the most accurate leading predictors of a recession in the coming year is the 10-year to two-year Treasury spread. Since 1976, when the Fed began publishing this data, it has precisely forecasted every reported recession in the United States.