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The yield curve can be graphed on a standard XY axis.
- The X-axis represents the borrowing period (sometimes known as the maturity) of a particular loan, bond, or treasury note (all of which are known as debt securities). There is a wide range of such debt securities available on the market, whether that’s a 10-year treasury note, a five-year note, a two-year note, a one-year note, or even something much shorter, like a three-month note that reaches maturity in just over 90 days.
- The Y-axis represents the yield of the security. The yield is the percent interest that is paid when the bond, loan, or note reaches maturity. This is based on the principle that if you purchase a 10-year note from the U.S. Treasury that promises 5% interest, you will only receive that 5% interest if you wait the full 10 years to collect your money.
U.S. Treasury bonds do not promise high-interest rates, but they are considered very reliable. If you purchase a treasury note that promises a 5% interest rate upon maturity, you can confidently expect to receive your 5% payment at the prescribed time. This gives the U.S. government a very high credit rating, although that credit rating has been jeopardized by political brinkmanship with the U.S. debt ceiling.
3 Primary Types of Yield Curve
The yield curve most commonly analyzed by market analysts compares the interest rates paid by five types of U.S. Treasury debt: the three-month, two-year, five-year, 10-year and 30-year notes.
- In a normal yield curve, the yield paid by bonds increases with length. Therefore a 30-year bond pays more than a 10-year bond, which pays more than a five-year bond, which pays more than a two-year bond, which pays more than a three-month bond. Typically the yield rapidly leaps from a three-month bond to a five-year bond. The curve flattens out a bit from there, but in normal conditions, long-term yields will still be higher than short-term yields.
- In an inverted yield curve, the bond market’s short-term rates are higher than its long-term rates. That means, for instance, that a two-year treasury note will offer a higher yield than a five-year note. Under normal conditions, however, the longer-term bond would produce a higher yield. A yield curve inversion, and the bond rates that come along with it can upend the bond market and may portend worse economic conditions to come.
- A flat yield curve falls between a normal and an inverted yield curve. When market conditions cause yield curves to change from normal to inverted, or vice versa, they pass through a transitional period where nearly all the bond terms produce roughly the same yield. If the economy is transitioning from growth to contraction, the long-term yields will fall and the short-term yields will rise, creating this flattening effect en route to an eventual yield curve inversion. But eventually, the economy will return to growth and bond yields will return to normal conditions, passing through another flat yield curve along the way.
What Do the Different Types of Yield Curve Mean?
When the treasury yield curve is normal, it indicates investor confidence in future economic growth. However, this does not mean that savvy investors rush off to park their money in the longest-term bonds, even though they offer the highest interest rates.
- In a normal yield curve, there often isn’t a massive difference in the long-term yields offered by a 30-year bond versus the yields offered by a 5-year bond. Therefore many investors will opt for the shorter-term 5-year bond, reclaim their money at the end of those five years, and look for something new to invest in, such as stocks or real estate or new treasury notes. Yet some people stay out of the bond market entirely during a normal yield curve, because while bonds pay decently in a growing economy, stocks tend to pay even more.
- When the yield curve inverts, it means that investors and economists are pessimistic about long-term economic growth. The advantage to bond investing, however, is that you get locked into an interest rate when you purchase debt security—which is a good thing if the economy is trending downward. Therefore, in the early days of a yield curve inversion, many investors will try to buy up long term bonds before they decrease further in value. While they aren’t acquiring those bonds at their peak rate, they are nonetheless guaranteed some degree of economic certainty since the long-term bonds will pay their promised interest rates, even if overall economic activity declines further.
What is the Significance of the Yield Curve in Finance?
Bond investing is only one component of a nation’s overall economic activity. The stock market is another important component. Perhaps most important is the job market, since most people—from the U.S. to Europe to China—derive most of their income from wages, not investments.
- Nonetheless, the yield curve is considered an incredibly important economic indicator. Lots of financial journalism, such as the NPR podcast The Indicator, pays special deference to the yield curve as a symbolic representation of the economy at large. In fact, the yield curve is used as a benchmark for other debt in the market. This includes mortgage rates and bank lending rates, even those are also steered by the monetary policy of a central bank, such as the United States Federal Reserve.
- On Wall Street, the yield curve is used to predict changes in economic output and growth. The bond yields of both short-term and long-term debt securities tend to reveal a lot about the overall state of the U.S. economy, and the economy of any nation where government-issued debt is considered reliable investment security.
Learn more about economics and society with Paul Krugman here.