The yield curve is a graph that shows the interest rates on debt instruments of different maturities. It is a popular tool used by investors and economists to analyze the state of the economy and make investment decisions.
The yield curve is typically upward sloping, meaning that longer-term debt instruments have higher interest rates than shorter-term debt instruments. This is because investors demand a higher return to compensate them for the increased risk of lending money for a longer period of time.
However, the yield curve can also be flat or inverted. A flat yield curve occurs when longer-term debt instruments have the same interest rates as shorter-term debt instruments. An inverted yield curve occurs when longer-term debt instruments have lower interest rates than shorter-term debt instruments.
The shape of the yield curve can be used to predict future economic activity. For example, an inverted yield curve is often seen as a sign that a recession is on the horizon. This is because an inverted yield curve indicates that investors are pessimistic about the future of the economy and are demanding a higher return for lending money for a longer period of time.
The yield curve is also used by investors to make investment decisions. For example, investors who believe that interest rates are going to rise may invest in short-term debt instruments so that they can benefit from the higher interest rates.
Here is an example of a yield curve:
| Maturity | Yield |
|---|---|
| 1 month | 0.50% |
| 3 months | 0.75% |
| 6 months | 1.00% |
| 1 year | 1.25% |
| 2 years | 1.50% |
| 5 years | 2.00% |
| 10 years | 2.50% |
| 30 years | 3.00% |
As you can see, the yield curve in this example is upward sloping, meaning that longer-term debt instruments have higher interest rates than shorter-term debt instruments.
History of the Yield Curve
The yield curve has been used as an economic indicator since the early 20th century. However, it was not until the 1970s that economists began to seriously study the yield curve and its predictive power.
In the 1970s, economists such as Arturo Estrella and Frederic Mishkin found that an inverted yield curve is a strong predictor of a recession. An inverted yield curve occurs when short-term interest rates are higher than long-term interest rates. Economists believe that an inverted yield curve is a sign that investors are pessimistic about the future of the economy and are demanding a higher return for lending money for a longer period of time.
Since the 1970s, there have been eight recessions in the United States. An inverted yield curve preceded each of these recessions. However, there have also been a few instances where an inverted yield curve did not precede a recession.
Despite the occasional false positive, the yield curve remains a popular tool used by economists and investors to predict future economic activity.
Here is a brief timeline of the history of the yield curve:
- Early 20th century: The yield curve is first used as an economic indicator.
- 1970s: Economists begin to seriously study the yield curve and its predictive power. They find that an inverted yield curve is a strong predictor of a recession.
- 1980s-2000s: The yield curve is widely used by economists and investors to predict future economic activity.
- 2008: The yield curve inverts before the Great Recession, which is the worst economic downturn since the Great Depression.
- 2023: The yield curve inverts again, raising concerns about a potential recession in the near future.
The yield curve is a valuable tool for economists and investors. It can help to predict future economic activity and make informed investment decisions. However, it is important to note that the yield curve is not a perfect predictor of recessions. There have been a few instances where an inverted yield curve did not precede a recession.
A graphical representation of the interest rates paid on debt instruments (bonds) across a range of maturity dates.
The yield is shown on the vertical axis (x) while the maturity dates are on the y-axis. The bonds used all have the same credit quality.
There are three shapes it can take:
- normal (upward sloping)
- inverted (downward sloping)
- flat
Many look to the yield curve as an economic indicator and as a sign of what will happen with inflation. A lot of the focus tends to be in the relationship between the short end (left side) and the long end (right side) of the curve. The short end has closer maturity dates and, thus, are impacted my by the actions of the Fed.
As the curve flattens out and starts to invert, many feel this is a sign of recesssion.