Your Quick Guide To Yield Curves

When making financial investments, it’s important to consider the long-term impact. And while it may not be possible to foretell the future of our economy, there are several indicators that can help you make informed decisions.

For example, you might look at the unemployment rate or job growth. You could also examine consumer spending habits.

It might also be a good idea to find out what major investors think. Typically, serious investors are particularly interested in the treasury bond yield curve. The direction of this curve helps them decide how to invest their money based on the economy growing or heading for recession.

What Is Yield Curve And What Does It Tell Investors About Risk?

A yield curve, also called a treasury yield curve or bond yield curve, is a curved graph that compares the difference in interest rates between different bond maturities.

Yield curves can help investors visualize the strength of the U.S. economy. If you know what the different types of yield curves mean, you can get a sense of whether it’s a good time to invest heavily in your portfolio or take out a mortgage.

To understand how yield curves work, it’s essential to first understand how bonds work. Essentially, a bond is the money that an investor loans to a company or other institution with the agreement to be repaid with interest once the bond reaches maturity. 

The x-axis of the yield curve graph represents when bonds reach maturity – that is, when the bond needs to be fully repaid. The curve might compare maturities ranging from as short as 3 months to as long as 30 years. The y-axis represents yield, or the annual return of investment bondholders receive.

Yield Curve Risk: A Definition

Due to the ever-fluctuating market, investment involves risk which is why investors keep a close eye on the curve to predict shifts and respond accordingly.

When interest rates change, there’s a chance that the curve will also shift which impacts the price of treasury bonds. This phenomenon is known as yield curve risk, in which changing interest rates impact fixed-income instruments.

The Federal Reserve, or the Fed, controls the left side of the yield curve by adjusting the interest rates based on economic activity.

When the economy is thriving, the Fed increases short-term interest rates (yields) to reduce borrowing and limit inflation. However, the Fed will lower interest rates in a stagnant economy to encourage borrowing and promote economic growth.

This explains the inverse relationship between bond prices and interest rates. Lower bond prices cause yields to rise, while higher prices result in lower interest rates.

Types Of Yield Curves And What They Mean

There are several types of yield curves, each indicating potential directions that the nation’s economy might be headed in. You might hear experts refer to normal, steep, flat and inverted yield curves.

Normal Yield Curve

Because short-term bonds usually produce lower yields than longer-term bonds, a normal yield curve slopes up from left to right.

Long-term bonds bring higher yields because the risk of losing money is greater the longer investors keep their money in a bond. With that greater risk, though, comes the potential for more profit since investors ask for more interest with long-term bond repayment.

You’ll see a normal yield curve when investors expect the economy to continue growing at a normal pace.

Inverted Yield Curve

Unlike a normal yield curve, an inverted one slopes downward to reflect lower yields as bond maturity dates get longer. In this scenario, short-term interest rates are also higher than long-term rates. An inverted yield curve usually indicates that the economy is headed towards a slowdown or recession.

When investors fear that the economy is slowing down, they tend to invest more in long-term bonds because they’re a safer option. Doing so increases the demand for these bonds. Higher demand causes long-term interest rates to drop, creating an inverted yield curve.

At the end of 2006, for example, the yield curve inverted and stayed that way into 2007; the Great Recession followed shortly after.

Steep Yield Curve

A steep yield curve typically indicates the beginning of economic growth after a slump. Its shape is similar in appearance to the normal yield curve.

The difference, though, is that a steep curve has a larger gap between long- and short-term interest rates – meaning that short-term bond yields are falling while long-term yields are rising. Long-term bond prices will consequently increase.

You might see a steep yield curve after the Fed lowers short-term interest rates. Lower interest rates encourage borrowing, as banks can borrow at lower rates while lending at higher ones. Higher interest rates will soon follow along with rising inflation.

Flat Or Humped Yield Curve

When the economy is undergoing a transition, a yield curve may become flat or humped.

A flattening curve indicates that interest rates on short- and long-term bonds are nearly equal. You’ll notice that there’s no upward or downward slope from left to right like with the normal curve.

The yield curve becomes humped when yields on medium-term bonds are higher than rates on lower- or longer-term bonds. This makes the curve higher in the middle and lower on the left and right side, giving the appearance of a hump.

A flat or humped yield curve may indicate that the curve will eventually become inverted. However, it could also serve as a warning sign that an economic slowdown is coming even if the curve doesn’t become inverted.

What Yield Curves Mean For Mortgage Rates And Investing

Investors aren’t the only ones who can benefit from paying attention to the yield curve. The yield curve also impacts prospective homebuyers.

If you’re financing your home with a mortgage, the yield curve influences your mortgage interest rate. How so?

Historically speaking, bonds and mortgage rates have had an inverse relationship. When bond rates are higher, mortgage interest rates are typically lower. This can lower your interest rate which also lowers your monthly mortgage payment. However, the yield curve is just one determining factor. Your credit score, loan term and type, down payment and more also play a major role. 

No matter what the investment, it can never hurt to be up to date on the yield curve and how it will affect you – not just in the present, but well into the future.

How To Check Yield Curve Rates

To learn more about the current Treasury bond yield curve rates, visit the official website of the U.S. Department of the Treasury. Here you’ll be able to find interest rates attached to bonds with different maturity dates, ranging from 1 month to 30 years. You can also explore past yield curve rates.

Yield Curve FAQs

Learn the answers to some frequently asked questions about the yield curve.

What is meant by yield curve?

The yield curve is a graph that visually represents the difference in interest rates between varying bond maturities. Investors use the yield curve to predict the health of the economy and to make informed investments.

What yield curve indicates a recession?

An inverted yield curve is the result of long-term rates being lower than short-term rates. When long-term rates are lower, this strongly suggests that an economic slowdown or recession is approaching.

How much should I consider the yield curve when buying a home?

Paying attention to the yield curve can help you during the home buying process. You may choose to take out a mortgage when bond rates are higher, since this could result in a lower mortgage rate. However, you’ll also want to consider more personal factors such as credit score, debt-to-income ratio, loan type and terms.

What is the risk of the yield curve?

The yield curve risk refers to the risk associated with investing in fixed-income instruments, as market rates are ever changing. When yields increase, bond prices increase. On the other hand, when bond prices decrease, interest rates increase.

The Bottom Line

The yield curve visualizes how the yields of bonds differ with varying maturity dates. The yield curve is one helpful tool investors and consumers alike can use to make informed financial decisions.

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