Why Yield Curves Exist
A yield curve is a line that represents the yields (interest rates) of bonds with similar credit ratings but various maturities. The yield curve’s slope provides insight into potential future changes in interest rates and economic activity. The three primary yield curve forms are flat, inverted, and standard (both of which have an upward slope).
The Function of a Yield Curve
Due to the risks involved with time, a standard yield curve has longer maturity bonds paying out more than shorter-term bonds. An inverted yield curve may indicate an impending recession with greater short-term rates than long-term yields. The proximity of the shorter- and longer-term rates on a flat or humped yield curve indicates an upcoming economic shift. There are several yield curves, including:
The curve of Normal Yield
A typical yield curve suggests that rates on longer-term bonds may continue to climb in response to times of economic expansion. As a result, many investors would temporarily store their money in shorter-term securities to eventually invest in longer-term bonds for greater returns when they anticipate longer-maturity bond yields to rise even more.
Flat Yield Curve
Depending on the state of the economy, an inverted or normal yield curve may birth a flat yield curve. The rates on longer-maturity bonds typically decline and potentially rise when the economy shifts from expansion to slower growth or recession, inverting the usual yield curve into a flat yield curve.
The yield on longer-maturity bonds is expected to climb, and the yield on shorter-maturity securities is expected to decline as the economy moves from a recession period to one of recovery and probable expansion, bending the yield curve from inverted to flat.
Inverted Yield Curve
The rates on longer-term bonds may continue to decline, coinciding with times of economic contraction, according to an inverted or downwardly sloping yield curve. Many investors would buy longer-maturity bonds to lock in rates before they further declined if they anticipated that longer-maturity bond yields would become even lower.
A down-sloped yield curve is further inverted due to the increasing onset of demand for longer-maturity bonds and the lack of market for shorter-term securities, which causes higher prices but lower yields on longer-maturity bonds and lower costs but higher yields on shorter-term securities.
FINAL INSIGHT
There are two main reasons why the yield curve is significant. First and foremost, it reveals to us to what extent all investors see the economy as a whole. The collective view of all market players is the best indication of what is happening if you believe in the efficacy of free markets.
The yield curve is significant for the second reason, which arises naturally from the first. The yield curve significantly influences the money supply in the economy. Another way to say it is that the yield curve affects people’s and companies’ capacity to get conventional bank loans. Banks can borrow money at short-term rates from their depositors or the Federal Reserve Discount Window. Then, at higher interest rates, it lends money to individuals like you and me. Banks are compelled to offer loans with lower interest rates if the market does not want higher rates (yield premium) because of uncertainty about future growth.
