What is a yield curve?

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Yield curves can illustrate a rate of return over time for any investment relationship, but the yield curve that is most often referenced in the news and in economic discourse is related to the government’s securities that investors can buy.

Can the yield curve predict recessions?

One of the reasons treasury bond return spread is one of the most-watched economic indicators is that the yield curve has a pattern of foreshadowing recessions. Economic expansion tends to happen during the yield curve’s upward climb, and inverted curves often appear before recessions. A downward-sloping curve, the inverted curve, has appeared before each recession over the last 50 years.

But an inversion in the yield curve is not a guarantee of a recession. At one point in the mid-1960s, a downward-sloping curve appeared, but no recession followed. Although the yield curve did invert in 2019, the recession that occurred in 2020 was unique — it is unclear if any economic action to address that inversion would have been able to mitigate the subsequent impact of the COVID-19 pandemic.

The Federal Reserve concludes that the predictive power of the yield curve can, at best, be attributed to reverse causality.

What are Treasury securities?

“Security” is an umbrella term for the three types of investments that can be made through the US Treasury: bills, notes, and bonds. The different names signal different lengths of investment terms: less than one year for bills, two–10 years for notes, and 20–30 years for bonds.

Investors buy Treasury securities to loan money to the government because, after a set period of time — from one to 30 years — the investor will get a return, or yield, on their investment.

This relationship is illustrated on a graph through a yield curve.

The yield curve connects points on a graph that reflect the interest rates for Treasury securities, which can change based on the length of the investment. In what economists consider a “normal” scenario, a two-year investment would have a lower rate of return than a 10-year investment.

The x-axis of a yield curve graph shows the maturity of the bond, that is, the length of time the investor is allowing the government to borrow money. The y-axis of the graph shows yield, the interest rate expressed as a percentage.

The rates of return, connected by a line over time and plotted on a graph, create the yield curve.

What changes the shape of the yield curve?

There are three forms the yield curve can take — an upward, downward, or flat curve.

Economists and investors pay attention to the direction of the curve because it is one measure of the economy’s health: It can signal whether it is moving toward a period of expansion or contraction, and it has a history of foreshadowing recessions.

Upward yield curve

When the yield curve line is rising, also referred to as a “normal” curve, it means that rates for short-term investments are lower than rates for long-term investments.

So a two-year investment will have a lower rate of return for an investor than a 30-year investment. This is considered a “normal” curve shape, because the longer an investor lends their money, the higher the risk they're taking, and therefore, they expect a higher reward.

Flat yield curve

When yield curves start to flatten, it means the gap in rates for short-term investments and long-term investments is narrowing — a two-year note may provide investors with a rate closer to the typical 30-year bond rate. A flattening curve is often an early signal to investors that economic growth may be slowing and that a recession is coming.

Downward or inverted yield curve

If the flattened line starts to dip and slope downward, it means that rates for short-term investments are higher than rates for long-term investments. Investors with two-year notes have a higher rate of return than those with 30-year bonds.

An inverted yield curve sounds the alarm for economists and investors tracking the likelihood of recession because it indicates that investors are expecting short-term interest rates to go up.