What is the Yield Curve? Definition and Meaning
The yield curve, often referred to as “term structure of interest rates,” is a curve that plots the yields or interest rates for a certain debt contract with different maturity dates (the final payment date of a loan or other financial instrument).
The curve reveals the relationship between the interest rate and the time to maturity of a security. It allows investors to compare the yields offered by short-term, medium-term and long-term bonds.
A bond yield curve looks at bond yields and their relationships over time for similar groups of bonds. Essentially, it can be a way to read what the bond market is thinking about the current economic climate on a graph. It is a snapshot of what bond markets think about the economic environment and what may be about to happen next.
An example would be measuring the dollar interest rates paid on U.S. Treasury securities with a variety of different maturity dates.
“A graphical representation of the relationship between the yields and maturities of different bonds of similar quality, currency denomination and risk (usually government bonds).”
The yield curve is often used as a benchmark for other debt in the market, including bank lending rates or mortgage rates. The most common yield curve observes the three-month, one-year, two-year, and five-year U.S. Treasury debt.
The yield curve measures the difference between short-term and long-term interest rates. Short-term rates are normally lower than the long-term ones.
The shape of the yield curve says a lot about future interest rate change. The three main shapes are: normal, inverted and flat.
A normal yield curve – long term maturity bonds have a higher yield than to short-term bonds.
An inverted yield curve – short-term yields are higher than the long-term yields. This can be an indicator of a recession.
A flat yield curve – the short-term and long-term yields are almost the same.
The shape of a yield curve indicates future interest rates, which in turn can determine whether an economy will either expand or contract. They can provide economists with a lot of information about the current and potential future outcome of an economy.
Professor Campbell Harvey, at Duke University, demonstrated that inverted yield curves have occurred just before the last five U.S. recessions.
Yield curves are typically published by financial institutions, major business newspapers (such as The Wall Street Journal), and the Federal Reserve.
Video – Yield Curve