Yield curves are a useful tool for investors and economists looking to get an indication of future interest rates and economic activity, based on investors’ expectations. Simply, a yield curve consists of a graph plotting the interest rates of bonds with different maturation dates but the same credit rating. It offers a snapshot of investors’ expectations over a set time period.
The US treasury yield curve is subject to particular scrutiny in this regard, with yield plotted against three months, two years, five years and thirty year US treasury debt.
According to Investopedia.com, the US treasury yield curve is used as the benchmark for things such as interest rate policy and mortgage lending, as can be used to try and predict future interest rate changes and economic growth prospects from an informed standpoint.
Yield curves generally come in three shapes, humped, inverted or ‘normal’. The normal shape for the treasury yield curve sees a gradual rise in the line of yield against maturity in a fairly smooth curve. This positive slope is considered normal because longer-term debt generally attracts higher yield because the greater period of time introduces higher levels of risk. A normal yield curve also indicates that investors believe the Federal Reserve are likely to raise interest rates in the future, a sign of economic confidence which indicates a period of growth (as a rule, interest rates are raised mostly to combat concerns about inflation when the economy is growing).
If short-term bonds are showing a higher yield than longer-term debt, then this results in an inverted yield curve, with the curve falling away to the right of the graph in a negative slope, and in the case of the treasury yield curve this can be an indicator of an upcoming recession, with investors believing that the Federal Reserve are likely to be cutting interest rates, in response to an economic slowdown.
Finally, if short-term and long-term bonds are showing similar yield levels, this can result in a flat or humped curve. Again, this deviation in the normal pattern of the yield curve indicates some form of future economic upheaval or transition.
Even the slope of the curve is subjected to analysis, as a steep slope highlighting a sharp contrast between short and long-term rates can also indicate some form of coming turbulence in the markets.
While the treasury yield curve is examined carefully, and fluctuations in its shape are taken seriously by investors, it has to be remembered that it only represents an indicator of future economic conditions, and could even be one of the factors which has lead to the old joke that: “Economists have accurately predicted eight of the last three recessions.”