A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but different maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt.
There are three main types of yield curve shapes: normal, inverted and flat (or humped).Yield curves may be created for any type of fixed income security, including US Treasury securities, investment grade and high-yield corporate securities, global bonds, and municipal bonds. The yield curve for US Treasury securities is considered a market benchmark, as it is often used as a basic reference point by fixed income investors to evaluate market conditions.
It is also used as benchmark to evaluate the relative attractiveness of investing in non-US treasury securities. This is because US Treasuries, in Theory have no credit risk, so the extra yield offered by a similar maturity, non-US Treasury security should offer adequate compensation for any additional risks incurred by the investor.
A normal yield curve signals that investors expect the economy to expand.
An inverted yield curve, on the other hand, occurs when long-term yields fall below short-term yields. An inverted yield curve indicates that investors expect the economy to slow or decline in the future, and this slower growth may lead to lower inflation and lower interest rates for all maturities. An inverted Yield curve typically indicates that central banks are “tightening” monetary policy, limiting the money supply and making credit less available.
A humped yield curve indicates an expectation of higher rates in the middle of the maturity periods covered, perhaps reflecting investor uncertainty about specific economic policies or conditions, or it may reflect a transition of the yield curve from a normal to inverted or ice-versa.
There are three main theories that attempt to explain why yield curves are shaped the way they are.
- The “expectation Theory” states that expectations of rising short-term interest rates are what create a positive yields curve.
- The Liquidity preference hypothesis” states that investors always prefer the higher liquidity of short-term debt and therefore any deviance from a positive yield curve will only prove to be a temporary phenomenon.
- The segmented market hypothesis states that different investors confine themselves to certain maturity segments, making yield curve a reflection of prevailing investment policies.
Because the yield curves is generally indicative of future interest rates, which are indicative of an economy’s expansion or contraction, yield curves and changes in yield curves can convey a great deal of information.