In business and finance, people talk a lot about "the yield curve." They usually mean the curve that appears when you plot the yield (rate of return) of Treasury bonds as a function of their time to maturity. While that may sound like insider jargon for finance professionals, the shape of that curve is widely referenced in mass media because it has become one of the most closely watched recession predictors in the world.
What Is the Yield Curve?
A yield curve is the collection of all the different yields on bonds being sold by an issuer (or sometimes a whole category of issuers) and their associated times to maturity (the final repayment date). The "curve" is the shape that those data points make when graphed, or the shape of the line that connects the dots, so to speak.
Consider a company or government issuing bonds (an investment that pays investors back with interest). For reasons explained below, bonds that pay back their investors sooner usually offer lower rates of return (yields) than bonds that pay off later — assuming all other factors are equal. So, for example, a bond that pays back its investment in a year might have a yield of 2%, while one that takes 10 years to repay investors might pay 4%.
The most closely watched yield curve is the one that plots the yields of bonds, aka fixed-income securities, issued by the U.S. Treasury (or "Treasuries" for short). And when people talk about the yield curve, without any other context, they mean the yield curve of those Treasuries (at least in the United States).
Key Takeaways
- "The yield curve" usually refers to the set of yields on Treasury bonds on any given day, plotted as a function of how long the bonds take to "mature" (pay back investors).
- The shape of the yield curve is influenced by expected future changes in interest rates, which means it reflects investors' expectations about future economic conditions.
- Both theory and history tell us that an inverted yield curve can be an advance warning that a recession is coming — but it provides little information on how soon or how severe that recession may be.
The Yield Curve Explained
Truly understanding why the yield curve is so important to economic analyses requires detailed knowledge of the principles and mechanisms by which bond markets operate. Professional investors may wish to skip this section.
Let's start with a basic question: What's a yield? To investors, "yield" means a specific interest rate: the promised rate of return on a bond, which is a type of fixed-income security. The security is called "fixed income" because its repayment dates and payoff amounts are set in advance. Bonds "mature," meaning, they end. There's a date on which an investor gets his or her final (often largest) payment, and the bond ceases to exist — it is no more. The yield is the annual rate of return that the bond pays on a buyer's initial investment. A bond that costs $1,000 today and pays $1,080 when it matures next year has a yield of 8%, while an otherwise identical bond that pays $1,050 has a yield of 5%. Some bonds mature in one year (or even less), while others go out to 30 years. A 30-year bond with a 5% yield may cost $1,000, then pay $50 a year, every year, until the final year, when the investor gets the initial investment back with the final interest payment (a $1,050 final payment).
Bond yields are established by a market mechanism in which investors buy bonds from the original issuers and then buy and sell those bonds among themselves. The same way the stock market sets prices for shares of stock, markets also set prices (and, therefore, yields) of bonds. If a $1,000 bond matures next year and pays $1,080, selling it at $1,000 is selling at a yield of 8%. Selling that bond for $990 would imply a higher yield (it's a higher rate of return when $990 grows into $1,080 than when $1,000 grows into $1,080). A selling price of $1,010 would imply a lower yield than 8%. As this example shows, yields and prices move in opposite directions. If an investor — or government or business — is selling or issuing a bond (issuing means selling a bond you create instead of one you bought from someone else), that seller wants a lower yield because it means a higher price. Investors who are buying bonds, on the other hand, want a higher yield (i.e., a lower price).
How Yield Curves Work (Or, Short-Term Rates Impact Long-Term Rates)
The last bit of market mechanism necessary to understand the yield curve is how short-term yields influence long-term yields. Consider bonds with one- and two-year maturities that both pay 5%. If rates never changed, and you wanted to make a two-year investment, it wouldn't matter whether you bought the two-year bond today or a one-year bond today and another one-year bond a year from now when the first bond pays out. You'd wind up with the same amount of money in two years either way, all else being equal.
Why Yield Curves Are Important
But what if you were convinced that interest rates were going to increase a year from now? Suddenly, the one-year bond looks more attractive because you could reinvest your money after year one at a higher rate and end up with more money in two years' time than you would if you bought the two-year bond. Yields on the two-year bond must rise to make investors willing to buy it. Conversely, if you were convinced that in a year's time one-year bonds would pay less than 5%, you'd prefer the two-year bond because it locks in a higher rate. This is how short-term interest rates impact long-term interest rates: The expected changes in short-term rates impact what kind of long-term rates investors are willing, eager or hesitant to accept.
Constructing a Yield Curve
Now let's define the yield curve. It's a graph where the x-axis is time to maturity of bonds and the y-axis is the yield of those bonds. Each bond from 30 years down to one year or less has a point on the graph that represents its maturity and yield, and the yield curve is the line drawn through the points to connect the dots. It's a curve of yields, as a function of the bonds' time to maturity.
You can draw lots of yield curves for different types of bonds, from AAA-rated municipal bonds to corporate "junk bonds." But when people talk about "the yield curve," they mean the one for U.S. government debt — bonds issued by the U.S. Treasury. These bonds are common, well-understood and frequently traded (meaning, they're highly liquid and there's good, current data about yields). They're also seen as being among the safest investments in the world. Here's the yield curve for U.S. Treasuries on May 5, 2022:
Clarifying vocabulary. Listen closely, and you'll hear investors talk about Treasury "bills" (or T-bills) and Treasury "notes" (T-notes), as well as Treasury bonds. In the world of Treasury securities, "bonds" usually refers to long-term bonds (those with 20- and 30-year maturities), while "notes" is shorthand for "medium-term bonds" (maturing in two to 10 years) and "bills" refers to the shortest-term securities (less than two years). Since they're all technically bonds, to reduce possible confusion I refer to them all as bonds in this article.
What Influences the Yield Curve?
The influences that shape the yield curve come from the market conditions that determine Treasury bond yields and from one very important interest rate: the federal funds rate. The fed funds rate is set by policymakers at the U.S. Federal Reserve and has a powerful influence on how the market prices bonds. Let's explore each of these influences.
How Market Mechanisms Influence the Yield Curve
Yields, even on new bonds that come directly from the issuer, are mostly determined by market conditions. New bonds are usually auctioned off, in which case the market directly sets the price, although sometimes they are sold to an investment bank or consortium of banks, which negotiates a price with the issuer. Either way, once bonds are issued to their first investors, they can be traded in the secondary market at different prices and yields — whatever the market will bear. Markets set bond yields via price negotiation between buyer and seller, the same way the stock market sets share prices. If the market price for a bond paying $1,020 next year is $1,000, the market yield for that bond is 2% (and if the price is below $1,000, the yield will be higher, while a higher price would result in a lower yield).
So how do investors decide on good bond prices? The first thing investors care about is risk, or how safe their dollars are. Riskier investments need to pay higher yields (i.e., be priced lower) to attract investors because of the higher chance that the investment will never get fully repaid. This is one reason that the slope of most yield curves has some upward pressure: Longer waits carry higher risk that something could happen to disrupt the safety of the investment before it's paid back, so longer-term bonds need to pay higher yields, all else being equal.
But when it comes to default risk, Treasury bonds are seen as being as close to risk-free as an investor can get. Therefore, changes in the Treasury yield curve are almost entirely due to changes in market conditions, as opposed to changes in the creditworthiness of the bond issuer. That's a big reason why the Treasury yield curve is so closely watched as a bellwether for market conditions.
Another thing investors care about is liquidity, or how easy it is to get their money out of the investment if they need it. This is another reason why yield curve slopes have upward pressure: If you have to sell a bond before its maturity, the longer you hold it the better the chances that market conditions will have changed and the price may have dropped. Just because you can hold a bond to maturity and get all your money back doesn't guarantee you'll be able to recoup your entire initial investment at any point between purchase and maturity. So, investors tend to want a little more yield as compensation for liquidity risk. But again, with Treasuries, investors generally need not worry about actually finding a buyer for their bonds should they need to sell (even though Treasury bonds of different maturities do have different liquidities, so there is a very small risk that an investor may have to accept a lower price if selling a lot of a less-frequently traded maturity).
How the Fed Funds Rate Influences the Yield Curve
The federal funds rate is a special interest rate controlled by the Federal Reserve's Federal Open Market Committee (FOMC). This is a very short-term rate, the overnight rate at which financial institutions lend to one another. But in a world where Treasury bonds from four weeks to 30 years are set by market forces, how much impact can a single, policy-managed, one-day rate really have?
A lot, as it turns out. Remember that long-term rates are influenced by short-term rates. In a previous example, the one-year rate (and expected future changes in it) influenced what kinds of rates investors were willing to accept on two-year bonds. The same logic applies to the overnight rate as well. Just as, next year, a two-year bond becomes a one-year bond, a one-year bond becomes an overnight loan in 364 days. So, if shorter-term rates are expected to be high and stay high, longer-term rates will be high as well. If shorter-term rates are expected to fall and stay low, longer-term rates will fall. And there are no shorter short-term rates than the fed funds rate, which makes the power to set that rate a very powerful policy lever, indeed.
So, why might the Fed use that lever to raise or lower rates? To maintain the economy in a state of steady expansion, which, more specifically, means managing its dual mandate: to support both high levels of employment and a stable currency value (i.e., keeping inflation low). Raising rates is a common way to fight inflation. Higher interest rates mean that borrowing is more expensive, which means that money isn't as "cheap" as it was before. It can be a way to tap the brakes on the speed at which money flows through the economy or, said another way, make borrowed dollars slightly harder to come by, which means they're scarce, which has an anti-inflationary effect. Think of simple supply-and-demand principles: When things are scarce, they're worth more. Lowering interest rates is a way to stimulate the economy by making investments cheaper, be they in new business ventures or in personal assets typically bought with financing help (such as homes and vehicles). This is why the fed funds rate moves around; it changes in response to economic conditions.
Expectations about the future of the economy, then, inform expectations about what the Fed will do with interest rates, which, in turn, influence what kind of yields investors are willing to accept on bonds. Said another way, on any given day, the yield curve represents market expectations regarding economic developments and policy responses to those developments. Which brings us to…
Why Are Different Shapes of Yield Curves Important?
If you're a bond trader or investment banker, yield curves are going to be important to you every day. If you're a business school professor or economics blogger, you'll encounter them slightly less often, but still fairly frequently. For business leaders and managers, the yield curve is probably newsworthy only when its shape becomes unusual, because that typically means the market is expecting changing — and uncertain — economic times ahead.
Normal curve:
When the yield curve is normal (slightly upward sloping, steeper on the left with the shorter-term bonds), that's a sign that economic conditions are expected to remain stable, or status quo, for the time being.
Steep curve:
When the yield curve gets unusually steep and upward sloping, that's a sign that the market expects interest rates to rise, with high probability and/or by large amounts. This often happens when inflationary pressures are significant and persistent enough to warrant a strong policy response, and traders think the Fed will raise rates to combat that inflation.
Flat curve:
When the yield curve gets flat, that could be a sign that rates are expected to drop and there's uncertainty ahead — in other words, some expectations of the future are offsetting the normal upward pressures on the curve's slope.
Inverted curve:
The shape that's most closely monitored and is consistently the most newsworthy, however, is an inverted yield curve. It's newsworthy because inverted yield curves tend to precede economic recessions. An inverted yield curve is one that slopes downward, despite all the upward pressure to rise. It means investors are willing to pay more (accept lower yields) for longer-term bonds than for shorter-term bonds. Why would they do that? In most cases, it's because they expect that when they get paid back from the shorter-term bonds, interest rates will be a lot lower. So, they will wish they had locked in a higher rate for a longer time, even if that long-term rate was lower than the then-current short-term rate. Different experts measure inversion differently, but most metrics involve looking at the point where a particular shorter-term rate (the three-month and two-year rates are very popular) is higher than a chosen longer-term rate (usually the 10-year rate).
Humped curve:
If a yield curve shows a hump, that means market investors expect medium-term rates to be higher than short-term rates and long-term rates. One of several possible interpretations is that humped yield curves are inverted yield curves where the inversion starts later, suggesting that a recession is predicted but not until after rates rise. Humped curves are rare — but the Treasuries yield curve was, in fact, humped in April 2022, as discussed next.
Using Yield Curves to Forecast Recessions
Inverted yield curves reflect strong expectations of future rate-cutting. Why might the Fed cut interest rates in the future, and why might bond investors believe it will do so dramatically enough to cause an inverted yield curve? Interest rate reductions are an effective form of economic stimulus, and a common response to a recession. And that, in a nutshell, is why an inverted yield curve is seen as a harbinger of tough economic times ahead.
However, yield curve inversions aren't always easy to determine. Sometimes the curve isn't entirely downward sloping, but does have a hump. For example, on April 1, 2022, the yield curve shown below sloped upward through the three-year rate (2.61%) before declining through the 10-year rate (2.39%). If you were measuring inversion by comparing the 10-year rate to the three-month rate (0.53%), you'd say it's not even close to becoming inverted; comparing the 2.39% of the 10-year to the two-year at 2.44% would lead to a “slight inversion, but fairly flat” conclusion. But from the 2.61% peak at three years, the curve shows a steady, almost linear decline to the 10-year rate. When dealing with less simple shapes, it pays to look at the whole picture and not just track a single metric marking the difference between two numbers, as news organizations frequently do for the sake of simplification.
The shape of the April 1, 2022 yield curve tends to reflect expectations that interest rates will rise and then fall. Many economists expect that shape anticipates the need to fight inflation, followed by a need to fight a recession.
Recessions don't always come immediately after a yield curve inverts. Sometimes a yield curve will invert, normalize and invert again before that happens. Sometimes it's a long time between an inversion and the next recession. The yield curve also can't tell you how bad a recession will be. But despite these shortcomings, among all the recession indicators economists have identified, an inverted yield curve is one of the most consistently reliable.
What Do Yield Curves Tell Businesses?
Knowing that an economic downturn is on the horizon is powerful for businesses, which can then take appropriate action to make their operation as recession-proof as possible. And the yield curve is among the best recession indicators we have.
Yield curves and business cycles.
Because the shape of the yield curve is at least partially based on expectations of future rates, and because future fed funds rate changes are often policy responses to economic conditions, many analysts and forecasters use the yield curve to infer market expectations for economic cycles. But while the yield curve is a good predictor of bad times ahead, it's less effective at predicting good times. An inverted yield curve is a particularly good predictor of recessions because the upward pressure on the slope means that the shape is biased toward a positive slope — more simply, the yield curve is biased against signaling a recession. So, when a recession signal is observed, it usually represents a fairly strong market prediction. Using an upward sloping yield curve to forecast a positive turn in business cycles, however, is riskier, since that's the natural shape absent any strong predictions.
How Do Yield Curves Impact Businesses?
Beyond recession forecasting, yield curves can have another value for business managers. For companies looking to access capital markets from which to borrow money, finding a yield curve of comparable bonds (e.g., similarly creditworthy corporate bonds instead of Treasuries) usually provides an excellent way to estimate borrowing costs. Smaller companies may be able to note unusual shapes to guide borrowing decisions as well.
For example, a very steep curve may mean borrowing costs are expected to rise markedly, so borrowing earlier could save money, compared to waiting until the last minute. A humped or bumpy yield curve could mean it's a good time to shop around and ask your lenders about different lengths of loans, to see where rates might be most favorable.
Conclusion
The Treasury yield curve is closely watched because it can tell business leaders a lot about market expectations for the economy. While at first blush it may seem like reading tea leaves or Tarot cards, translating the shape of a curve into economic forecasts has real economic theory behind it. Even more important than theory, an inverted Treasury yield curve has, in practice, repeatedly demonstrated its value as a useful recession indicator.
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Yield Curve FAQs
What does the yield curve tell you?
A yield curve tells you the yields of a set of fixed-income securities (bonds) as a function of their time to maturity. When people talk about the yield curve, they usually mean bonds issues by the U.S. Treasury. Certain shapes of the yield curve can tell you about expected future changes in interest rates, and an inverted yield curve (one that slopes downward) is a commonly watched indicator that may foretell a coming recession.
Why does the yield curve matter?
The yield curve is important because of its usefulness in forecasting economic conditions. An inverted yield curve has a good track record for predicting recessions.
What does a normal yield curve look like?
A “normal” yield curve is typically upward sloping, steeper on the left and flatter on the right, similar to a square root or log function. Normal yield curves slope upward because investors typically (though not always) demand higher yields for longer-term investments; they generally require accepting more risk and less liquidity than shorter-term investments.
