Secrets of the Yield Curve Revealed

You might hear the term “yield curve” in the news, but it still may be unfamiliar. Although a yield curve is a snapshot of interest rates, it’s not a topic reserved for bond investors. Find out how it works, what it’s signaling about the economy and markets—and how it’s useful when making decisions about your investments.

What is the yield curve?

A yield curve is a visual representation at a single point in time of the yield differences between bonds of the same credit quality but different maturities—i.e., the time remaining until a bond's principal amount is repaid. While people plot yield curves for various types of bonds, the one most often referenced is the U.S. Treasury yield curve, which compares the yields of short-, intermediate- and long-maturity Treasuries.

What does the shape of the yield curve tell us?

Because yields change over time, the shape of the curve also changes. For example, the curve could be normal (upward sloping), inverted (downward sloping) or flat depending upon the prevailing yield environment. Investors often look to the shape and movement of the yield curve as a signal for where the economy is headed.

What is a normal yield curve?

A normal yield curve is an up-sloped curve that shows yields gradually increasing as bond maturities increase. This reflects the general idea that money invested for longer periods of time is exposed to more risk and should therefore garner greater potential rewards, including higher yields. Normal or rising yield curves are typically apparent during periods of economic growth.

What is an inverted yield curve?

An inverted yield curve is a down-sloped curve that shows yields gradually declining as maturities increase. Why would long-term investors accept a lower yield for a longer-term commitment? When the curve is inverting, investors may expect yields to continue to fall, so they invest to lock in the current rate. Because of the association with lower interest rates, investors see an inverted yield curve as a sign of a slowing economy or recession.

What is a flat yield curve?

A flat yield curve occurs when shorter- and longer-maturity yields are close, creating more of a flat line than a curve. This may be because shorter-maturity yields have risen or because longer-maturity yields have declined, or both. Investors generally view a flat yield curve as an indicator of slower growth.

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What is the "yield spread"?

When discussing the yield curve, many people also refer to the yield spread. This number is the mathematical difference between the yields of short- and longer-maturity securities, typically the two- and 10-year Treasury notes. In general, a positive and rising yield spread as maturities lengthen indicates the curve is normal or steepening; a declining or negative yield spread would reflect a flattening or inverted curve.

How can the yield curve be useful to me?

Because the yield curve may signal where the economy is headed, it also sheds light on the return expectations investors have for the stocks and bonds you may have in your portfolio. In general, the flattening of the yield curve suggests potentially slower growth and weaker longer-term inflation expectations, and a steepening indicates economic growth, interest rates and inflation may be on the rise.

One of many factors to consider

Keep in mind yield curves and yield spreads are always changing. They are one of many factors that experts watch to gauge the health of the economy and the direction of interest rates. While it's helpful to understand and follow these concepts, it doesn't mean that you need to make a move in your portfolio.

We believe the best approach to weathering various markets is creating a diverse portfolio with an investment mix suited to your investing time frame and comfort with risk.