What do yield curves tell us

But when people reference the yield curve, they generally mean the yield curve that tracks U. Treasury securities. Treasury yield curve as an example. In exchange, the Treasury promises to return their principal investment after a set period of time—at maturity—and pay them a fixed rate of interest on the loan—a.

While the coupon does not change over the maturity of a U. Treasury, its yield is always fluctuating. The horizontal Y axis tracks maturity—in the case of the U. Treasury yield curve, the Y axis starts on the left with short-term Treasury bills, having maturities from a few days to one year, then proceeds to Treasury notes with maturities of two, three, five, seven and 10 years, and finally ends on the right with bond maturities of 20 and 30 years.

The vertical X axis indicates the current yield earned by each maturity. A yield curve offers an easy-to-understand visual snapshot of a given bond market at a single moment in time. Typically, it shows you average yields on short-, medium- or long-maturity bonds from a given day or week of trading.

Interest rates on bonds sold by the same issuer with different maturities behave quite differently, depending on how investors are feeling about risk, trends in the broader market and the performance of the economy as a whole. A yield curve lets you visualize the different rates for different maturities on one chart.

Comparing bonds of different maturities from the same issuer lets investors work out the right investment strategy. Tying up money in a long-term bond means risking the possibility of rates increasing during the life of the security, and a yield curve can help investors make sense of that risk. As the curve flattens investors receive less compensation for investing in long-term bonds relative to short-term and are less inclined to do so.

Yield curves take on different shapes depending on the state of the individual bond market and the economy overall. Each shape suggests a different potential outlook for bonds and is classified as normal, steep, inverted, flat or humped.

A normal yield curve slopes up and to the right as yields increase with maturity. This indicates that market conditions and the economy as a whole are healthy and functioning normally. In short, yields are distributed this way because in an ideal world investors want to be compensated more for having their money tied up for the long term. That means issuers must provide a so-called liquidity premium that grants longer-term maturities higher yields.

This incentivizes people to buy them over more liquid shorter-term bonds. A steep yield curve looks like a normal yield curve but with a steeper slope. Market conditions are similar for normal and steep yield curves. But a steeper curve suggests investors expect better market conditions to prevail over the longer term, which widens the difference between short-term and long-term yields.

When the rates for shorter-term maturities are higher than those for longer-term maturities, that creates an inverted yield curve. In this case, the yield curve slopes down to the right instead of up. This can indicate a recession or bear market , where the market may experience prolonged declines in bond prices and yields.

Measure content performance. Develop and improve products. List of Partners vendors. If you invest in stocks, you should keep an eye on the bond market. If you invest in real estate, you should keep an eye on the bond market. If you invest in bonds or bond ETFs , you definitely should keep an eye on the bond market. The bond market is a great predictor of inflation and the direction of the economy, both of which directly affect the prices of everything from stocks and real estate to household appliances and food.

A basic understanding of short-term vs. The terms interest rates and bond yields are sometimes used interchangeably but there is a difference. An interest rate is the percentage that must be paid to borrow money. You pay interest to borrow money and earn interest to lend money when you invest in a bond or save money in a CD. Most bonds have an interest rate that determines their coupon payments , but the true cost of borrowing or investing in bonds is determined by their current yields.

A bond's yield is the discount rate that can be used to make the present value of all of a bond's cash flows equal to its price. A bond's price is the sum of the present value of all cash flow that will ever be received from the investment.

The return from a bond is commonly measured as yield to maturity YTM. That's the total annualized return that the investor will receive assuming that the bond is held until it matures and the coupon payments are reinvested. YTM thus provides a standard annualized measure of return for a particular bond. Bonds come with a variety of maturity periods from as little as one month to 30 years. Normally, the longer the term is the better the interest rate should be. So, when speaking of interest rates or yields , it is important to understand that there are short-term interest rates, long-term interest rates, and many points in between.

While all interest rates are correlated, they don't always move in step. Short-term rates might fall while long-term interest rates might rise, or vice versa. Understanding the current relationships between long-term and short-term interest rates and all points in between will help you make educated investment decisions. The benchmarks for short-term interest rates are set by each nation's central bank.

In the U. The FOMC raises or lowers the fed funds rate periodically in order to encourage or discourage borrowing by businesses and consumers. Its goal is to keep the economy on an even keel, not too hot and not too cold. Borrowing activity overall has a direct effect on the economy. If the FOMC finds that economic activity is slowing, it might lower the fed funds rate to increase borrowing and stimulate the economy.

However, it is also concerned with inflation. If it holds short-term interest rates too low for too long, it risks igniting inflation. The FOMC's mandate is to promote economic growth through low-interest rates while containing inflation. Balancing those goals is not easy. Long-term interest rates are determined by market forces. Primarily these forces are at work in the bond market. If the bond market senses that the federal funds rate is too low, expectations of future inflation will rise.

Long-term interest rates will go up to compensate for the perceived loss of purchasing power associated with the future cash flow of a bond or a loan. On the other hand, if the market believes that the federal funds rate is too high, the opposite happens. Long-term interest rates decrease because the market believes interest rates will go down in the future. The term "yield curve" refers to the yields of U. Treasury bills , notes , and bonds in order, from shortest maturity to the longest maturity.

The yield curve describes the shapes of the term structures of interest rates and their respective times to maturity in years. The curve can be displayed graphically, with the time to maturity located on the x-axis and the yield to maturity located on the y-axis of the graph. For example, treasury. Treasury securities on Dec. The above yield curve shows that yields are lower for shorter maturity bonds and increase steadily as bonds become more mature.

The shorter the maturity, the more closely we can expect yields to move in lock-step with the fed funds rate. Looking at points farther out on the yield curve gives a better sense of the market consensus about future economic activity and interest rates.

Below is an example of the yield curve from January The slope of the yield curve tells us how the bond market expects short-term interest rates to move in the future, based on bond traders' expectations about economic activity and inflation. This yield curve is "inverted on the short-end.

High demand, in turn, drives up interest rates. Higher inflation is usually caused by strong economic growth. Thus, in periods of economic expansion, investors expect the bond yields with longer-maturity to be higher than shorter-term because they expect future higher interest rates as well as inflation. A steep yield curve is typically a positive sign for the economy, meaning that investors expect higher interest rates and inflation.

It indicates investors are confident about putting money into stocks and private sector bonds, therefore long-term government bonds have to offer higher yields to attract buyers.

In mid-February , the short-term, two-year interest rate was 0. That 1. Below was the upward sloping yield curve from mid-February On the other hand, slower economic growth reduces the demand for money when businesses are less likely to produce more or finance projects with loans.

Lower demand for loans puts downward pressure on interest rates. Also, during weaker economic growth, the Fed is more likely to reduce short-term interest rates to encourage people to borrow and spend.

For example, the FOMC lowered its target for the federal funds rate to near zero at the end of to support the economy during financial crisis. 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 investors are uncertain about the future path of the economy, including aggregate demands, inflation and the future value of stocks and bonds.

In December , the short-term, two-year interest rate was 2. That 0. An inverted yield curve happens when s hort-term interest rates are higher than long-term rates. This seems like a paradox at first glance — why would investors settle for lower yields holding longer maturity compared to shorter-term? This is because they expect the future rates to be even lower, as they have little to no faith in the economy going forward.

A negative term spread typically, the difference between year and 2-year yield evidently predicts weaker economic growth in the future with a high probability of recession.

Economic research shows the yield curve was inverted measured in terms of the difference between year and 1-year treasury yields prior to every recession from January to February Although inversion of the yield curve is considered a harbinger of a recession, the inversion alone does not necessarily indicate an impending recession.

In February , the short-term two-year interest rate was 4.